CHAPTER TEN

TRADITIONAL GOVERNMENT ACTIVITIES II

Economy, Finance, and Taxation Systems

In this chapter we add another traditional set of government activities to our comparative discussion—the one dealing with the financial and economic side of administration and government.

For most of history, government economy and finance were centralized and in the hands of rulers. Most economic activity was financed based on indirect taxes and taxes in labor and in kind. Modern governments are predominantly financed on the basis of direct taxes, but there is variation across countries. Also, there is variation in the degree to which subnational governments have latitude to raise revenue as they are dependent upon national governments. With regard to developments in expenditure, we will find striking similarities between countries.

The chapter reflects upon the core economic functions and cumbersome constraints that emanate from growing demands in modern societies. Following those demands, economically oriented reforms have propagated all over the world for the last decades. We will consider the way in which varying economic conditions have issued different answers forged by countries, in order to face local and global challenges mandated by the modern zeitgeist.

Our discussion will be divided into three sections. First, we will overview some core prospects of the economic and finance conditions in a set of different countries from various continents and cultures. Next, we will probe some taxation systems in various countries and see that, although looking for the same outcome, they are quite unique and specifically structured to respond to the respective challenges of countries. Finally, we will try to provide some comparative dimensions amongst countries.

Akin to other chapters, we confess that no full comparison is possible considering the disparate immense subjects and the complexity of the national systems. However, it may serve as another brick in the wall of comparative effort to understand our governmental and administrative realm.

Economy and Finance

Once people became sedentary, they established physical trade markets where they could exchange their own products with those manufactured elsewhere. City-states and empires alike regulated trade and taxed it. It was not until the nineteenth century that it became clear that an abstract “free market” could not exist without government regulation. Indeed, the laissez-faire economy was the product of deliberate state action (Polanyi, 1944, p. 141). The notion of a government-protected free market has a strong hold across the globe. Based on experiences in Latin America, the economist John Williamson defined a set of specific policy recommendations known as the Washington Consensus, and they included fiscal policy discipline (avoiding large fiscal deficits), directing public spending from subsidies to pro-growth and pro-poor services (such as primary education, primary health care, and investments in infrastructure), and tax reform (Williamson, 1993). The term “Washington Consensus” refers to a set of specific neoliberal economic principles that should constitute a standard policy reform package for crises-wracked developing countries. These should be promoted by Washington-based institutions such as the World Bank, the International Monetary Fund, and the U.S. Treasury Department. In this section we will look more closely at the intertwinement of the economy and of finance in times of reform and crisis, especially since the end of the twentieth century. We will look at cases from the developed world but also from developing countries, and in a comparative view. This can demonstrate to the reader how governments deal with policy concerns, learn from one another but also remain quite different at the same time.

Romania: Restructuring Agriculture in a Transition Economy

More than two decades after the formal end of the socialist economic experiment, structural change revolves around constant changes in deployment of factors of production. Within agriculture, workforce has downsized, the number of farms has fallen off, and so has the proportion of those employed in agriculture, affecting rural livelihoods and labor markets, productivity, and profitability (information in this section is drawn from Buchenrieder and Mollers, 2009; Davidova and others, 2009; Rizov and others, 2001; Rizov, 2003; Luca, 2007, 2012; Salasan and Fritzsch, 2009; Campos and others, 2010). Reorientation to farming in Eastern Europe has given rise to a large number of tiny (semi-)subsistence farms that have not necessarily reacted to the same policy signals as larger commercial farms. Nonfarm activities can unfetter families from poverty and spur rural development, since those who have found employment elsewhere exit the farming sector, allowing more competitive farms to grow.

After World War II, the communist regime had created cooperative farms via forced collectivization of land and assets of individual farmers; by 1989, there were around 3,800 cooperative farms with an average size of around 2,400 hectares using 59 percent of agricultural land. State farms were large-scale, capital-intensive enterprises organized on land that had been confiscated from the royal family and large landowners after World War II, so in most transition countries agricultural production was organized in large-scale collectives or state farms under communist rule. Since the state controlled most agricultural land, the share of private land ownership amounted to barely 9.45 percent, although it varied considerably between counties.

Despite vigorous attempts at industrialization under the communist regime, Romania retained a strong rural culture, since the agricultural sector was the backbone of its economy. Agricultural employment accounted for around 30 percent of total employment in the 1980s. In addition, a large number of nonfarm workers were farming part time. Agriculture was organized into three kinds of enterprises: state farms, cooperatives, and small private individual farms. When Romania embarked on economic reform at the beginning of the 1990s, state and collective farms were restructured and assets of agricultural production were privatized.

Following the breakdown of the communist system in Romania, cooperative farms have been completely transformed into agricultural societies, farmers associations, or individual farms. Individual farming has had the advantage of lowering transaction costs associated with the need to supervise labor and reduced inefficiencies owing to codetermination. Potential disadvantages might have involved the loss of economies of scale in risk management, provision of information and credit, input purchasing, marketing, and production. Apart from that tradeoff, the shift to individual farming has been further influenced by the costs for individuals to leave the collective farm and start up an individual farm. These costs are affected by land reform, privatization, and pertinent regulations. According to the European Commission (EC, 1998 cited in Rizov, 2003), by 1997 more than 3.5 million individual farms with an average size of 2.3 hectares occupying 58.6 percent of total agricultural land dominated Romanian agriculture.

In 2004, the government undertook to stimulate the transformation of peasant households into commercial family farms by consolidating land through exchanges and free market transactions, support for investment in livestock farms, and introducing life annuity for old peasants who were willing to give up their land in favor of those farmers who were willing to modernize and grow. Pensions, however, had been so low that agricultural activity on any scale was not an option but rather a must for most pensioners, which kept them trapped in the sector. Agricultural farms that had enjoyed a sound footing were the most obvious beneficiaries of the foregoing “Sapard” program because they could insure finances and cofinance investment projects, some of which were sponsored not only by the national government but also by the European Union (EU). The “Farmer” program was adopted in 2005 to enhance activity in the rural area by attracting loans and investments for the Sapard program; it had been set up by the Ministry of Agriculture but was carried out through banks and financial institutions selected through a public bidding process. That national program supported investments in agriculture and in other sectors connected to the specifics of agricultural activities such as processing, storing, preservation, and marketing.

After Romania joined the EU in 2007, its agriculture became part of the EU's agriculture. Since the 1970s, the number of farms in the EU has tapered off as labor was replaced by technology and capital, the result being more equipment and fewer workers using almost the same agricultural area. In 2012, the change in Romania's economic profile was revealed as it turned out that agriculture's share in GDP had gone down by half from about 14 percent in the first half of the first decade of 2000 to around 7 percent in the second part of that decade. In Romania, as in other EU member states, farm size had the tendency to increase with economic development. For the long haul, higher agricultural income per worker on the larger-size farms has been an argument in favor of farm consolidation. Europe's Common Agricultural Policy transfers had been traditionally absorbed by large-scale, efficient producers and even more so after the 2003 reforms that linked subsidies to farm size. In the short and medium term farming practices matter the most, so applying modern technologies has been paramount in terms of long-term performance and gains. Many small and medium farms have met with declining labor productivity, chiefly in areas locked into a poverty trap—a combination of unfavorable initial conditions and economic collapse both in agriculture and in nonfarm sectors. Poorly developed market infrastructure, low productivity, and lack of capital bear heavily on smallholder (subsistence-oriented) plots.

Low productivity of small- and medium-size farmers, by tradition grain producers in interaction with certain speculative actions, has often rendered farmers' incomes insufficient to modernize despite possibilities for support from EU funds. Even though agriculture in itself can no longer be a major source of economic growth, the challenge for Romania's agriculture (and food industry) has been to bring down the deficit from agrofood trade.

During recent years, Romania has managed to reduce poverty. Already in 2008, the United Nations Development Program (UNDP) in Romania could indicate a reduction of severe poverty for the last five years from 10.5 percent in 2002 to 4.1 percent in 2006 and in rural areas from 17.5 percent to 7.1 percent. Disparities between rural and urban regions have nonetheless persisted, which has been ascribable to overall economic development. On the other hand, agriculture has served as a social safety net for many millions of people. Rural poverty may be further alleviated by creating nonfarm jobs in rural areas to provide income opportunities for surplus labor. Both new farmers and potential nonfarm employees seem to require profession-specific advice and training in order to become competitive in their transition environment. Pensioners could be convinced to exit the agricultural sector if their income from social provisions covered their daily needs.

Spain: Faltering Growth, Wavering Employment Rates—An Economy Veering between Prosperity and Downspin

Under Franco's dictatorship, the system of industrial relations had rested on rigid employment protection legislation (EPL) and a ban on unionization in exchange for lifetime job security; during the late 1970s, the first democratic government in Spain found it hard to dismantle that system. EPL gives differential treatment to different groups of workers, particularly in regard to dismissal. Regulations created a wedge in firing costs across workers because they have varied with age, gender, skill, firm size, and type of contract. European and Latin American countries have attempted to increase labor market flexibility through marginal changes in EPL that liberalized the use of fixed-term (or temporary) contracts, whereas legislation concerning the stock of employees under open-ended (or permanent) contracts has been left almost untouched (information in this section from Bentolila and others, 2008, 2011, 2012; Éltető, 2011; Muñoz de Bustillo and Antón Pérez, 2012; Neal and Garcia-Iglesias, 2012; Ferreiro and Serrano, 2012).

From the second half of the 1990s until 2007 Spain experienced a spectacular period of economic growth in which its GDP per capita had reached 90 percent of the EU-15 average. The recession of the early 1990s had left high public deficits in its wake, but afterward they tapered off and a surplus was even achieved between 2005 and 2007. Unemployment rates that had been habitually high waned to below 10 percent during that golden decade. This is even more remarkable when taking into account that during that time the number of immigrants quintupled, amounting to 5.7 million foreigners in 2010, making up 12.2 percent of the population. Between 2000 and 2008, immigrants' employment rate mounted from 1 percent to 14.8 percent, since the labor market was easily able to absorb these people. Foreigners took on approximately half of the vacant jobs created during this period in services, tourism, agriculture, households, and mostly in the construction industry. The labor force participation of women almost doubled from 37 percent in 1996 to 66 percent in 2009, adding up to 3.9 million extra jobs.

Spain had started a process to become a full member of the EU in 1986, and by 2002 it was admitted into the European Monetary Union (EMU). Spain had been undergoing economic and social changes throughout that process to align itself with its European neighbors. Peripheral countries that joined the Eurozone by 2002 were forced to maintain a fixed nominal exchange rate with their more advanced trading partners. However, their real exchange rates continued to appreciate as long as their domestic inflation rates were higher than those of the more advanced Eurozone economies and they could also borrow at favorable interest rates from the rest of the world and apply that surge of funds to whatever projects they desired. This proved to be housing in the case of Ireland and Spain, government services in Greece, and government construction in Portugal, but in each case, the most desirable investment was in nontradable goods or services. Access to cheap financing through the facilities of the European Central Bank (ECB) coupled with soaring prices of nontradables (service sector labor, land, and housing) became a common denominator of many peripheral European countries under the EMU's operating rules.

The subprime mortgage crisis in the summer of 2007 was only a prelude to a worldwide round of financial upheavals that swept developed, developing, and emerging economies alike in 2008. The Greek crisis of 2009 that brought to light its swollen sovereign debt gave rise to a second round of financial turbulence that did not skip Spain. Relaxing access to credit triggered an investment spurt, which, alongside inflow of immigrants, led Spain to specialize in low value-added, labor-intensive industries (construction, tourism, personal services, and so forth).

Economic growth in Spain relied heavily on the construction sector whose size in GDP terms rose way above the EU average of 6.2 percent, from 7.2 percent in 1997 to 12.1 percent 10 years later; during that decade one out of every five jobs created in Spain had to do with construction. Two-thirds of the housing units built in Europe between 1999 and 2007 were built in Spain. The government cultivated those mega-investment projects with thousands of houses and residential areas even more after 2003 when it liberalized use of constructible land, drastically boosting its value. Housing prices tripled in nominal terms and doubled in real terms between 1995 and 2008, spawning a construction bubble.

The peculiarities of the Spanish labor market go back to the Franco era, during which wages and productivity were low and jobs were protected in order to maintain social peace. Trade unions were illegal, and collective bargaining was dominated by employers at the province or industry level. Following the democratic transition of the late 1970s, union delegates have been awarded a substantial prerogative at all levels of collective bargaining: state, province, and firm.

Spain's dual labor market dates back to Law 32/1984 that sought to reallocate workers from decaying industries to more profitable ones against a backdrop of oil shocks. In the wake of the second oil crisis that had bloated oil prices, unemployment rates surged following massive layoffs in energy-intensive sectors such as mining, shipbuilding, and steel. Unions opposed any attempt to alter the status quo, so the only politically feasible way to adjust the labor market was by liberalizing temporary contracts. These so-called employment-promotion contracts enabled employers to hire temporary workers performing regular activities and stipulated substantially lower dismissal costs than permanent or open-ended contracts; their termination could not be appealed to labor courts. After working three years at most within the same firm, the employer had to either terminate the contract at no cost or convert it into an open-ended one. That two-tier reform inflated the proportion of temporary contracts to almost 35 percent in the early 1990s, turning Spain into the EU nation with the largest share of temporary employees. Conversion rates into permanent contracts were strikingly low since firms used layoffs as a workaday practice.

From 1992 onwards, a series of EPL reforms attempted to counteract undesirable effects of the 1984 reform. Their aim was to reduce the incidence of temporary jobs either by restricting the use of temporary contracts or by reducing firing costs for open-ended contracts. Subsequent reforms (enacted in 1992, 1994, 1997, 2001, 2002, and 2006) mitigated the gap between the two modes of employment, but the employment market has remained bifurcate. Fixed-term contracts bore mainly on immigrants, as they went from representing 1.3 percent of the labor force in 1996 to 16 percent in 2008; over that period, 61 percent of them were on fixed-term contracts vis-à-vis 33.6 percent of the general population. Employers have been using those contracts mostly as a flexible device to adjust employment in the face of adverse shocks rather than as a screening device under asymmetric information, which has accounted for the low conversion rate of fixed-term contracts into permanent ones.

Spain's elastic, two-tiered employment structure throws light on its economic trajectories both during the boom and during the crisis. In terms of lost GDP, some of Spain's European counterparts were hit harder; in 2009 Germany and Ireland lost 4.7 percent and 7.6 percent, respectively, whereas Spain lost 3.7 percent, lower in fact than the EU average (–4.1 percent). Nevertheless, the Spanish labor market has shed redundant labor at a much faster pace than its European counterparts have. Before the crisis, Spain had played a major role in European employment growth; after 2008, it became associated with unemployment, accounting for 29 percent of EU employment losses from 2008 (3rd quarter) to 2009 (3rd quarter). In macroeconomic terms, Spain has been the epitome of quantity adjustment as a strategy for coping with falling demand: The loss of employment for each percentage point of reduction in GDP was four times higher in Spain compared to the EU average.

By the end of 2011, the unemployment rate had grown to almost 23 percent; toward the end of 2012, it neared 25 percent. The duality of the Spanish labor market has rendered it highly dysfunctional. On the one hand, industrywide bargaining agreements impose unprecedented rigidities such as severance pay of up to 45 days per year of service for dismissal of permanent workers—a level found in no other European country. On the other hand, temporary contracts make it easy for employers to lay off workers during economic slowdowns. Apart from their obvious shortcomings, fixed-term contracts hamper productivity growth over the long haul, since employers are unlikely to invest in temporary employees' human capital.

Even when employment rates and economic growth had spiked, productivity did not rise and competitiveness even deteriorated; productivity needs to grow as well for the sake of sustainable growth. Raising productivity by increasing human capital and developing a qualified workforce has entailed remodeling the unsatisfactory education system. One of its principal, sad features has been early school leaving. Spain ranks among the leaders in that respect in the EU: 33 percent of 18- to 24-year-olds left school with few or no qualifications and were no longer in education in 2009 while the EU average was only 14.4 percent. The construction boom had lured many young people to leave education in order to work in this sector, but when the real estate bubble burst, they found themselves without work and dependent on welfare benefits. Although university costs in Spain are not high for students, a shortage of skilled labor has developed over the past decade. Spain does not rank high on indicators of education, traditionally lagging behind its European counterparts in PISA tests (PISA is an international study that was launched by the OECD in 1997, aiming to evaluate education systems worldwide every three years by assessing 15-year-olds' competencies in reading, mathematics, and science). In 2009, Spain was again significantly below the OECD average in all respects, as no Spanish university made it to the list of the top 200 universities in the world. Innovation could be another basis for long-term growth, but Spain has been lacking in this regard as well. Small and medium-size enterprises have accounted for more than 80 percent of private employment, but their research and development efforts have been weak, since corporate R&D activities have been concentrated in a group of large enterprises.

The Spanish government is unlikely to put much money into the education system or other social spending, for that matter, anytime soon, having to scale back public spending in order to finance its sovereign debt and meet the Maastricht criteria regarding long-run debt and annual deficit levels taken as debt-to-GDP ratio of 60 percent and deficit-to-GDP ratio of 3 percent. Spain has asked the EU and the IMF for a rescue package. Amid the southern peripheral nations, Spain has had the lowest debt-to-GDP ratio but the highest level of unemployment. In the spring of 2011, there were 1.38 million Spanish families whose members were all unemployed; many had become discouraged and left the labor force. In the following years, the threat of unemployment will continue to loom large in people's lives.

Greece: Footing the Bill for Laxity during the Ostensive Boom Years

For the past four years, Greece has starred in a saga of public finances. However, it has become more and more evident that Greece has not been the only nation in fiscal dire straits (information in this section from Buiter and Rahbari, 2010; Garcia Pascual and Ghezzi, 2011; Lynn, 2011; Wihlborg and others, 2010; Haidar, 2011; Matsaganis, 2011; De Santis, 2012). Most countries in the EMU fare worse than at any time since the Industrial Revolution, with the exception of wartime episodes and their immediate aftermaths. Problems were not confined to the Eurozone but extended to EU member states not in the zone like the United Kingdom and Hungary, and to Japan and the United States.

The origins of this widespread loss of fiscal control are shared by most countries and can be traced to procyclical fiscal policy during the boom period preceding the financial crisis that started in August 2007. The situation in Greece nonetheless owes much to the unique features of its economy, political institutions, and policies.

Some of the failure to warn ahead was due to misleading statistics produced by Greek authorities that greatly understated its deficits. Since 1999, the Maastricht rules have threatened to slap hefty fines on euro member countries that exceed the budget deficit limit of 3 percent of GDP, whereas total government debt must not exceed 60 percent; the Greeks have never managed to stick to the 60 percent limit and adhered to the 3 percent ceiling alone. However, they did so with the help of blatant balance sheet cosmetics, since creative accounting took priority when it came to toting up government debt. Goldman Sachs, for example, had helped the Greek government mask the true extent of its deficit with derivatives that legally circumvented the EU Maastricht rules, but when the so-called cross-currency swaps matured, it swelled the nation's already bloated deficit.

On October 16, 2009, then-Greek Prime Minister George Papandreou disclosed the nation's severe fiscal problems in his first parliamentary speech. On November 5, 2009, the Greek government revealed a revised budget deficit of 12.7 percent of GDP for 2009, which was double the previous estimate. The incoming government admitted that earlier fiscal data had been misreported. The general government deficit for 2008 was corrected from 5 percent to 7.7 percent (later revised to 9.4 percent) of GDP. Dependence on foreign borrowing heavier than hitherto thought proved fatal: Markets reacted by increasing spreads (that is, interest rate differentials from German government bonds, which for many years had been deemed the safest assets in the world) and by lowering credit ratings. Since then, the sovereign spreads (representing the difference between bond yields issued on international markets by the country in question versus those offered by governments with AAA ratings) rose sharply for most of the Eurozone countries, causing the biggest challenge for the EMU since its creation.

Deep-rooted structural problems at all levels have taken their toll on Greece. Unlike other countries that had managed to curb social and welfare spending without fatally weakening core services and benefits, social spending in Greece soared, usually without visible improvements in outcomes, and reform efforts failed one after another: The welfare state edifice appeared to be unassailable. After joining the monetary union in 2001, Greece experienced a sharp decline in competitiveness as inflation consistently exceeded the Eurozone average, so Greece has been losing market share of exports relative to its EU peers. High administrative costs, high margins across most economic activities, and rising labor costs plagued the Greek economy. Poor governance and regulation has also been a hurdle to inward foreign direct investment (FDI), which has been low throughout these years. Being inefficient and making losses, state-owned enterprises have been a source of fiscal underperformance.

In March 2010, debt-ridden Greece was forced to take tough austerity measures; the EU promulgated that it would closely monitor the nation's efforts to cut its enormous budget deficit and get its public finances into shape. In light of Greece's imprudence and fraudulence, the European Commission, the EU's executive body, criticized Athens for faulty reporting of statistics and put Greece under closer monitoring than any Eurozone nation had ever been before. The announcement failed to placate the markets. In April, Standard & Poor's (S&P) downgraded the nation's credit rating to below investment grade (that is, junk status). As Greece lost access to the international financial markets, the sovereign debt crisis was in danger of evolving into a solvency crisis.

After much procrastination on all sides, an unprecedented 110 billion rescue package was agreed upon with the European Commission, the ECB, and the IMF (dubbed colloquially the “troika”), designed to cover the nation's borrowing requirements for the next three years. The Eurozone members provided 80 billion allocated in parallel with their relative ECB capital shares, whereas the IMF provided 30 billion. In return, the Greek government signed a Memorandum of Economic and Financial Policies ratified by parliament on May 3, 2010. The memorandum forced sweeping spending cuts and steep tax increases to reduce the nation's public deficit to below 3 percent of GDP by 2014. Greece also agreed to austerity measures such as to increase the value-added tax (VAT) rate from 21 to 23 percent, fuel and alcohol taxes by 10 percentage points, and reduce wages in the public sector including pensions and other fringe benefits. The minimum retirement age rose from 55 to 60, and privatization plans have been in store for a number of state-owned enterprises.

On May 4, 2010, protesters rampaged through the streets of Greece's major cities, venting their frustration over the austerity package imposed on the nation by the troika, as it appeared that the economy had gone off the rails as suddenly and violently as a train accelerating into a crash. The brutal and passionate riots encapsulating the fault lines and conflicts within the global economy lasted a few days. Three workers died as extremists set fire to a high-street bank in Athens. It was all to no avail since, in the harsh realities of global finance, when the money runs out, so do the options.

A pension reform and a first round of labor market reforms had been under way, but implementation fell behind schedule. The central government failed to front-load difficult policy decisions such as large cuts to the public sector wage bill, and subcentral governments' budgets proved difficult to control. Fiscal austerity, internal devaluation, and the credit crunch sent the economy into a downward spiral. Since the beginning of the crisis in early 2010 up to the end of 2011, Greek banks lost more than 20 percent of deposits. Now that access to international capital markets has been shut off, banks have had to rely on the ECB funding via regular open market operations and emergency liquidity assistance to the Bank of Greece.

For many months doubts have been cast whether Greece would be able to repay its debts in light of structural problems of its foundering economy, even if its debts would be softly restructured (such as, payments would be delayed and rescheduled while lowering promised interest rates) or even in case of out-and-out default. At the end of 2011, it seemed unlikely that, with interest rates around 15 percent, Greece would be able to return to the capital markets for its lending needs in 2013 and 2014. It was assumed that Athens would require an additional 60 million in loans from the troika. Greek debts have inevitably undergone massive “haircuts” (of more than 50 percent shared by private investors and governments alike, namely European taxpayers), restructuring, rescheduling, and buyback programs whereby Athens has repurchased sovereign bonds for a fraction of their face value. Toward the end of 2012 Greece hit rock bottom as S&P downgraded its creditworthiness again from a “CC” rating to “SD” (selective default).

Light was seen at the end of the euro-crisis tunnel in late 2012, when the European commissioner for economic and monetary affairs, Olli Rehn, proclaimed that the debt and financial crisis afflicting Europe's common currency zone has surpassed its apex (SPIEGEL International, 2012). Analysts expect Greece's rating to return to the “CCC” level. For the first time in the past years, a further “haircut” for Greece appears unlikely, and it seems that Greece has come to grips with its intractable structural problems. During the summer, Eurozone governments and the ECB stabilized the situation. Strict austerity measures applied in countries like Greece, Portugal, and Spain have reversed the negative trend. The combined budget deficit in the Eurozone fell from 6.2 percent of the currency area's GDP in 2010 to 3 percent in 2012 and a projected 2.5 percent in 2013, so Greece's candid efforts have ripened, starting to bear fruit. Instead of mere crisis management, policy shifted to structural issues across the board, stressing the competitiveness of all Eurozone and EU member states.

Given the structural nature of its economic problems, Greece will go through a slow and painstaking process in the following years. Inefficiencies in government require restructuring and/or privatizing loss-making public entities including more transparency in regard to public accounts and performance. Competition should be enhanced in markets of both products and services. Administrative burdens should be liberalized and reduced for all sectors including network industries, “closed” professional services, and retail trade. Labor market reforms are essential in order to regain cost competitiveness including regulatory changes to: (1) employment protection legislation; (2) the collective bargaining regime to favor wage moderation; and (3) promoting more part-time work to boost participation of the youth and women in the labor force.

Iran: The Paradox of Plenty—Replete with Hydrocarbon Reserves and Yet in a Pickle

The Iranian economy rests on oil revenues. With 10 percent of the world's oil and 14 percent of its gas reserves, Iran's hydrocarbon reserves are second only to those of Saudi Arabia (information in this section from Salehi-Isfahani, 2009; Esfahani and Pesaran, 2009; Marsh, 2009; Esfahani and others, 2012; Feizi, 2008; Mellati, 2008; Jahan-Parvar, 2012). Iran was originally earning small shares of its oil wealth, since the royalties paid to the government of Iran by the British holder of the oil concession amounted to barely 8 percent of the value of oil exports. After the concession had been renegotiated by Reza Shah's government in the early 1930s, Iran's share rose to about 15 percent. Following the 1953 coup orchestrated by the Eisenhower administration, Iran became a U.S. client state. Due to economic embargo, growing confrontation with the West over Iran's oil industry, and political instability, oil revenues dwindled down and investment came to a halt. After a new deal in 1954 that had retained 50–50 profit sharing (companies-Iranian government), Iranian oil was reintegrated into the world oil market.

Since imports outpaced exports by far, the IMF had set in motion the “Economic Stabilization Program” in 1959 to address the balance-of-payments crisis, followed by a series of reforms since 1963. Several programs redistributed agricultural land away from large landlords, sold the shares of public enterprises, required profit sharing for industrial workers, extended suffrage to women, formed literacy corps, and nationalized forests and pastures. From 1963 to 1976, GDP per capita grew by approximately 8 percent each year. Non-oil GDP per capita rose even faster—by 8.6 percent per year. With substantial improvements in infrastructure and public services such as roads, electricity, water, education, and health, Iran's agrarian-based economy turned rapidly into one mainly oriented toward services and industry. Western Europe became reliant on Middle Eastern energy resources.

After the oil crises of the 1970s, oil no longer followed a pattern of ownership equity. Host countries wanted to gain strategic control over their natural resources and would no longer settle for better contractual terms. Hitherto, a group of Western oil companies dubbed the “Seven Sisters” comprising Shell, AIOC, Standard New Jersey, Socony Vacuum, Gulf Corporation, and Texas and Standard of California had held sway over oil in terms of ownership, development, and delivery. That dominance started to wane when everything from tankers to drilling and engineering services could be contracted or purchased on the open market. The shah had capitalized on that regained strategic control to invest the extra revenues and overheated the economy, so that in the mid-1970s inflation started to climb. Draconian measures soon led to sharp declines in GDP and investment. Public discontent with policies in both economic and noneconomic spheres had grown, sparking a revolution that brought down the monarchy and established an Islamic republic.

The 1979 revolution marked the point at which Iran had broken free from foreign management of its oil, becoming the world's most important oil-producing nation that was hostile to the United States and could disrupt other oil supplies traversing the vital Strait of Hormuz. Saudi Aramco, CNPC of China, Russia's Gazprom, NIOC of Iran, PDVSA of Venezuela, Petrobras of Brazil, and Petronas of Malaysia have emerged as the new “Seven Sisters” that succeeded the seven old ones. Governments that have had difficult relations with the United States and the wider West have been the major owners of the sisters, which hold a third of the world's oil and gas production and more than a third of its oil and gas reserves, and jointly develop each other's reserves to the exclusion of other companies and interests. Iran has steered away from dollars and switched mostly to euros and yen paid by China and Japan in order to countervail U.S.-led economic sanctions.

A downturn had already betided the Iranian economy prior to the revolution of February 1979, but following the revolution it went into an out-and-out tailspin that lowered real GDP by almost a quarter of its 1979 Q1 value in the two subsequent years. After the Islamic Revolution fixed interest was banned because of Islamic rules, so firms could not be financed by selling bonds, and there was no advanced system of financial intermediation (for instance, venture capital). Redistributive and political conflicts undermined incentives for production and investment, since the government took over all large firms and all banks and financial companies, restricting trade and capital movements and expropriating property of those believed to be associated with the shah's regime. Protectionism flourished, property rights came into question, and the economy began to witness a major exodus of skilled labor and professionals. From 1980 to 1982, oil revenues plummeted and the rate of inflation rose sharply. The economy was also grappling with political instability and external conflicts. Extreme government control over the economy had not only reduced business incentives, but also created a shortage of raw materials for production. In the early 1980s, nonoil exports dropped to well below 1 percent of Iran's nonoil GDP. The war with Iraq (1980–1988) destroyed property and infrastructure and drained resources away from productive investment. Shortly after the war ended, oil revenues shot up, mainly during the 1990 Persian Gulf crisis. Under Rafsanjani's institutional and economic reform and reconstruction efforts, steps had been taken to dismantle the war economy but the postwar recovery was short-lived.

After a few years of market-oriented reforms, the government liberalized the foreign exchange market and opened up the capital account in 1993. The process had not been managed well, and the nation had quickly accumulated a huge stock of short-term external debt ($30 billion in just two years), followed by a major balance-of-payments crisis in 1993–1994. Economic liberalization was put off, import controls were tightened, the rial depreciated, imports went into short supply, and the economy came to a screeching halt in 1994–1995. Since firms that had borrowed abroad struggled to pay back their debts, the government decided to cover a substantial portion of the losses sustained by the borrowers because of devaluation. As public revenues had fallen and creditworthiness had become low, it was necessary to expand the monetary base. Consequently, the economy stagnated and inflation spiked. The government reintroduced a host of controls on foreign trade and payments as well as on domestic markets.

During Khatami's reign (1997–2005), reforms continued piecemeal when oil prices started to rise in 1999, engendering substantial growth for the first time in many years. In 1998, oil revenues totaled $13 billion; in 2005, oil revenues amounted to $48 billion. Iran established three free trade zones in the Persian Gulf to facilitate trade with neighboring countries and applied to join the WTO, but has been vetoed six times by the United States. In 2002, a new Law for Protection and Promotion of Foreign Investment paved the way for investment in nonoil sectors; between 2004 and 2009, the growth of the economy was around 5 percent per year.

Not unlike elsewhere, growth brought about by oil revenues has been unstable, so Iran has failed to sustain growth for the long haul. Since oil prices tend to falter, one (but not sufficient) measure to extenuate fluctuations may be to set up a stabilization fund to accumulate surplus during periods in which oil prices are high. Durable economic growth entails policies that ensure greater integration with the rest of the world by providing greater opportunities for diversification and substitution in the face of rapidly changing terms of trade. When it comes to the Islamic Republic, previous attempts to stabilize the economy through greater isolation may have done the exact opposite, since extensive interventions in trade and markets have strained relationships of domestic firms and producers with their foreign partners. This has stymied technological exchange and development, putting Iranian firms at a disadvantage.

The Iranian government should enhance its human capital while furthering innovation, entrepreneurship, and thrift; this is the seedbed of sustainable growth. This requires a more flexible labor market and educational reforms. Sustainable growth also stems from a substantive private sector. Long-lasting growth entails additional funds apart from those of the government, tipping the scales from “rent seekers” to people, local or otherwise, with money to invest. The private sector is not merely a passive agent for investing oil revenues; private investors expect reforms that guarantee the safety of their property and enforce contracts. They also need competitive markets, so their product and investment is not threatened by competition from government monopolies. They ask for trade reform and possible membership in the WTO. Finally, they require a highly skilled, educated, flexible, healthy, and innovative workforce.

Even when GDP was growing annually, dependence on rising oil revenues could barely sustain that process for long when deficient technological development has rendered labor, capital, and natural resources unproductive. Iran's labor force had become more educated, which together with declining fertility rates since the mid-1980s was expected to enjoy an unusually high proportion of working-age population in the next few decades. Prior investments in infrastructures in terms of health, education, and transportation, all of which have been necessary to foster investments that can make Iran more competitive in the world economy, have culminated in demographic transition that could have phased out reliance on oil wealth while hinging more and more upon human capital. Such transition, however, cannot come about absent adequate institutional underpinnings. First and foremost, the legal environment should be reformed to effectively govern and regulate property rights, contracts enforcement, and employment.

When it comes to high and sustainable growth, many developing countries outpaced Iran. With its phenomenal growth rate, China has been growing faster than Iran and has been joined more recently by India and countries in East and South Asia, Latin America, Eastern Europe, and even Africa. Iran has performed poorly even in comparison to most countries in the Middle East and North Africa, many of which have been notoriously lagging. Economic sanctions against Iran have been in effect in one form or another ever since April 1980.

Whether U.S. sanctions against Iran have been effective is debatable. Iran's imports and nonoil exports have become more geographically diversified as the share of G7 countries in Iran's imports has fallen substantially, with the United Arab Emirates and China filling the shortfalls created by U.S. sanctions. The nature and the scope of sanctions imposed by the U.N. Security Council are likely to be limited as all permanent members need to be on board, two of which are Russia and China—Iran's principal trade partners. Iran's defiant stand on nuclear issues may bring forth more sanctions. So far, two Security Council resolutions (number 1737 in December 2006 and number 1747 in March 2007) have restricted Iran's development of sensitive technologies in support of its nuclear and missile programs. The March 2007 resolution has also called upon all states and financial institutions not to provide new grants, loans, or financial assistance to the Iranian government.

Iran has already been engaged in protracted wars, coups d'état, political ferment, and economic upheavals that have taken their societal toll on its citizens. Further sanctions are likely to cripple the economy. The demographic trend may also take a turn for the worse. As of August 2012, the leaders of the Islamic Republic have officially ceased population control and insisted on a larger population even when the existing population faces severe underemployment or unemployment and unfunded social security and health commitments. Given the anemic pace of growth and job creation, such policies lead to more, not fewer, economic and social problems in a 15-year time period. It seems that the near future does not bode well for Iran and its people.

Tax Reforms: Taking for Giving

Historically taxes would be levied on labor, in kind, and on consumption. The bulk of taxes were raised on foodstuffs and are thus indirect taxes, the revenue of which cannot easily be predicted. From the nineteenth century on, governments have shifted to direct taxes mainly raised through income tax and social security taxes. That revenue can be predicted, and it enabled governments to finance the expansion of services beyond the traditional tasks of defense, policy, and justice. Many taxation systems became more progressive by nature, with the marginal tax rate increasing with income. Especially in the three decades since the Second World War, this resulted in decreases in income inequality. However, under the influence of growing beliefs in free markets, income inequality has risen in the past three to four decades (Piketty, 2013). Tax reform is one way of attempting to reduce undesirable levels of income inequality.

Denmark: Searching for the Magic Bullet to Reduce Income Tax Pressures and Labor Costs

Ecological or environmental tax reform (ETR) is used interchangeably. ETR increases taxes on the use of natural resources and on pollution as such or polluting products while lowering other taxes, usually those levied on employment. The rationale is that the tax burden should fall more on “bads” rather than on “goods” such that consumers and producers can modify their behavior according to the signals. Denmark taxed gasoline as early as 1917 (information in this section from Clinch and others, 2006; Dresner and others, 2006; Kloka and others, 2006; Holger and Hansen, 1999; Hougaard Jensen and others, 1999; Smed, 2012; Gwozdz, 2011; Stafford, 2012). Since the late 1980s, environmental taxation has been perceived less as a way to make polluters pay for environmental cleanup or protective measures but rather as a possibly more efficient economic or market-based instrument for environmental regulation as opposed to traditional methods of bureaucratic command and control.

When applying ETR, revenues may be recycled through tax reductions elsewhere (such as income taxes) or used to support environmental projects; otherwise, it may be used for compensation. Many European countries that grapple with high labor costs endeavor not only to lower energy consumption while abating pollution but also to relax the pressure on employment, so by pursuing that double dividend, they hope to reduce both energy use and unemployment. Some economic studies have begun to question the wisdom of the double dividend theory, emphasizing the uncertainty of secondary gains and how these might easily be outweighed by adverse economic effects of excessive environmental taxation.

In the wake of the first oil crisis of 1973, the government levied energy taxes on electricity, oil, and gas following deficits and poor national balance of payments. In 1985–1986, the taxes were raised considerably to contain national consumption at a time when both prices of crude oil and the USD-rate (exchange rate with the dollar) were falling. Nevertheless, most consumers were unaffected as all VAT-registered businesses had been exempted from energy taxes. Non-VAT-registered businesses such as banks and doctors had to pay the tax along with the public sector, and revenues were not recycled.

In the late 1980s' atmosphere of heightened popular concern about the environment, a broad consensus in parliament was behind the center-right coalition government of the time in taking on a high profile at the international negotiation table, pushing for ambitious mandatory reduction targets, effective implementation, and fair burden-sharing schemes. As part of its strategy to live up to the national CO2 reduction target, the government introduced a new CO2 tax on households and businesses alike and restructured energy taxes to better reflect environmental considerations. Chronically high unemployment levels had not abated despite apparent recovery from the 1980s recession; mounting public debts and income tax pressures have borne on the Danish economy for the past 50 years. “Green” taxation was expected to create new public revenue that would enable trimming both top and bottom levels of income tax, rewarding top earners while boosting low-income employment.

An intensive campaign organized by the Federation of Danish Industry raised awareness of the nation's potential loss of international competitiveness if energy prices would rise solely in Denmark. The center-right, traditionally business-friendly government was turned against the idea of a CO2 tax on businesses. After alternative “green” majorities in parliament had mobilized support, a CO₂ tax was phased in on top of existing energy taxes on coal, oil, gas, and electricity; it was imposed on households from January 1992 and on businesses from January 1993. A fair share was earmarked for subsidizing energy conservation projects of businesses and promoting decentralized power/heat generation and biofuels. A further share served to complete and subsidize the countrywide system of district heating. Although natural gas had been exempted from the new tax, gas companies were allowed to charge prices as if the new CO₂ tax had been imposed. Since the early 1990s, the European Commission had been airing proposals to levy carbon and energy tax in order to stabilize CO₂ emissions in the community; Denmark was among the first countries to jump on the bandwagon, and from 1992 on it has been cutting down on reimbursements given to businesses for taxes paid on gasoline and diesel.

Between 1994 and 1998, Denmark steered away from global income taxation, which applies a single progressive tax to the sum of the taxpayer's income from all sources, toward dual income taxation, whereby capital income is taxed separately from other sources of income. The marginal taxation of working income was reduced by a total of 2 percent of GDP financed through capital revenues (0.8 percent of GDP) and more “green” taxes on energy, waste, water, and sewage in particular. The piecemeal reform also taxed loopholes and levied new social contributions on both employers and employees. The social impacts of indirect environmental taxation on lower-income groups were compensated by reducing their taxation while increasing child support. The tax reform encumbered households with higher energy and waste taxes in addition to new taxes on water, plastic bags, and gasoline, whereas businesses were barely touched.

In return for the support of the left-wing parties in parliament, the text of the reform package included a commitment to look into further possibilities to impose “green” taxes on businesses. That commitment had been given by the Social Democratic government under the clear condition that the international competitiveness of businesses was to be taken into proper consideration. A committee summoned to dwell on that issue released its final report in early 1995 after hinging upon technical information provided by companies. Since the final definition process became quite responsive to a range of particularistic interests and considerations, almost all processes aside from energy for space heating were entitled to refunds, and in some cases to extra refunds in return for entering into agreements with the Danish Energy Agency with respect to energy efficiency; the CO₂ tax rate climbed, too.

Energy taxes on households rose again in 1999, this time as part of an overall package of economic measures taken to cool the economy that showed signs of overheating. In 2001, the center-left government contrived a budget proposal for 2002 setting forth a considerable rise in CO₂ taxation on businesses. Following the November 2001 general elections, the Liberal and Conservative parties had formed a new right-wing coalition government, and the suggestion was taken off the table. Over the period 1984–2000, green energy taxes expanded much faster than other taxes but still made up only 10 percent of tax revenue.

A large revision of the tax system in October 2011 attempted once again to reduce income tax rates for all people actively participating in the labor market, and to finance this by increasing not only energy and environmental taxes, but also those levied on consumer goods associated with adverse health outcomes. So-called “health taxes” on sugar products, soft drinks, cigarettes, and alcohol increased. Denmark became the first nation in the world to tax saturated fat after imposing a fat tax on the weight of saturated fat in case it exceeded 2.3 percent. Foods such as meat, dairy products, animal fats that had been rendered or extracted in other ways, edible oils and fats, margarine, and blended spreads were affected, so those who manufactured or imported them for domestic consumption were forced to pay more taxes; foods produced for export, on the other hand, did not attract the fat tax.

The tax inflated administrative costs and put jobs at risk because Danes made shopping trips to Germany and Sweden to avoid it. Opposed by farmers, food companies, and consumers alike, “the bureaucratic nightmare” had been short lived as barely a year into implementation it was repealed by the Danish parliament just as the tax ministry canceled its plan to impose a sugar tax on foods with added sugar such as yogurt, marmalade, pickles, and ketchup in January 2013. Denmark has to make do with present “health” taxes on chocolate, sugared soft drinks, and other sweets for the time being.

Belgium: Spurring Unemployed and Low Earners into Labor

Employment policy in Belgium, as in continental Europe at large, has traditionally focused on demand-side measures, probably due to industrial restructuring. In the last two decades, several EU countries tackled the inactivity trap of unemployment and low activity rates from a labor supply perspective through extensive tax cuts. Policy makers have pitched tax and social security contribution rebates to those unemployed or less-productive workers to impel them to take on paid jobs (information in this section from Orsini, 2006; Carey, 2003; Stockman, 2004; Vanleenhove, 2011).

The tax-to-GDP ratio in Belgium had been rising over recent decades from 31 percent in 1965 to 46 percent in 2000, becoming greater than both the EU and OECD averages and leaving Belgium with one of the heaviest tax burdens in the OECD. The share of personal income tax in total taxation grew larger while the share of consumption taxes declined; the share of social security taxes remained broadly unchanged. After a period of stability, the share of corporate income tax rose in the 1990s, reflecting both increases in effective tax rates and a rise in the share of profits in GDP. Compared to the EU average, the share of personal income tax was higher, whereas the share of consumption taxes was somewhat lower. As early as 1997, the government was concerned about the heavy tax burden in general and on labor in particular, pledging to reduce it bit by bit to the level in the three main neighboring countries.

At the start of the millennium Belgium had a massive tax burden owing to high public spending that was exacerbated by the enormous debt service cost associated with the public debt it had to accommodate. Since international tax competition had limited the scope to which this burden could be imposed on capital income, it fell mainly on labor income. In light of concerns regarding possible adverse effects on the labor market, the government gave priority to lowering the tax burden on labor. The effects of heavy taxation on the employment level of low-skilled workers are harmful; in Belgium, their employment rate has lain just above 55 percent. In the case of single and married women, high taxation has been even more detrimental: According to Labor Force Statistics, fewer than 40 percent of married women with less than secondary education have been in employment.

In 1999, the newly elected federal government catered to low-income earners by cutting employers' share of contributions to social security. The Additional Crisis Surcharge (ACS), which had been laid in 1993 during a budgetary crisis as a complementary tax added to the corporate income tax rate to fund social security, was to be phased out over 2001–2003; personal income tax was to be reduced further over 2002–2005. Motivated by international competitiveness concerns, the government reformed corporate income tax in a revenue-neutral way. These changes to taxation of both labor and capital purported to counteract adverse labor market effects of high taxation in order to make Belgium more attractive to direct investment and for multinational enterprises to declare their profits. After trimming employees' social security contributions for low-paid workers, the government passed a bill to rescind the ACS piecemeal.

In 2001, Belgian parliament reformed the personal income tax by relieving the tax burden and introducing refundable tax credit on low earnings. The reform was set up as a multitier measure estimated to cost 3.33 billion, amounting to a decrease of almost 10 percent in revenues from taxes. It comprised a tax credit for low-income earners, streamlined the marginal tax rates on medium income tax brackets, added job-related tax deductions, and removed marginal tax rates beyond 50 percent. As to couples and families, the 2001 reform raised exemptions for married couples to match those of unmarried couples with a double income, introduced tax cuts for double replacement-income earners except for unemployment benefits, discriminated nonwork from work-related income in terms of taxation, augmented tax allowances for dependent children, and mandated favorable fiscal treatment of environment-friendly investment. In 2004, a year prior to full implementation, a second reform amended some aspects of the tax regime. A tax rebate for social security contributions of low-skilled employees supplanted the planned tax credit on low earnings, since the former was supposed to be more effective in promoting the employment of the low skilled, because contributions tended to be extremely high even on very low earnings.

In 2007, the Flemish government launched an in-work tax credit, the Jobkorting, to spur inactive population into the labor market. The Jobkorting attempted to grapple with the unemployment trap, namely, the small financial difference between working and being unemployed due to the high tax wedge that kept inactive people out of paid jobs, as they had no real incentive to undertake salaried work.

“In-work” tax credits, subsidized social security contributions, and transfers conditional upon employment all fall into a group of measures referred to as Making Work Pay (MWP) policies prevalent in many countries under different titles. MWP policies have been designed as hybrid instruments to reshape the link between employment, solidarity, and social justice in the welfare state of the twenty-first century. Such policies aim for economic inclusion; that is, economic mainstreaming of society's most vulnerable individuals with positive feedbacks coming from decreased spending on income maintenance and poverty-related social problems like poor health or crime. More financial resources for the weakest fraction of the population also mean greater social cohesion.

From 2007 until 2010, the Jobkorting has been slightly altered. In tax year 2008, the Jobkorting gave a tax credit to people who earned more than 5,500 a year. Workers who lived in the Flemish region but earned less than 5,500 a year were not entitled to the tax deduction. Every worker who earned between 5,500 and 21,000 a year received a yearly tax credit of 125. After reaching a yearly income of 21,000, the credit began to phase out as each additional euro earned reduced the credit by 10 cents, so the credit disappeared if workers earned 22,250 a year or more. In the tax year 2009, the formula had not been changed, but the credit did not phase out after reaching a certain yearly income. Every worker who lived in the Flemish region and earned between 5,500 and 22,000 a year received a yearly credit of 300, which was reduced to 250 if the yearly income exceeded 22,000. In 2008 and 2009, the rebate was monthly; that is, every month the worker received a share of the total yearly amount of the tax deduction. In 2010, the yearly amount was given entirely in the second month of the year.

The decrease in the working effort of the population already in employment almost outweighed the increase in hours worked coming from new labor-market entrants. When it comes to changes to the tax system, low-income households tend to be extremely reactive, whereas higher-income households tend to be on average less reactive due to the interaction between substitution and income effect. It also has been found that joint assessment of income for purposes of both taxation and benefit eligibility has unambiguous negative effects on the labor supply of secondary earners, mostly women. While MWP policies can be very effective in promoting the labor supply of the low skilled, the relatively negligible Jobkorting led to minor changes in the labor supply, since married women altered their labor supply the most. The tax credit failed to enhance the employment efforts of low earners because it was simply too modest. When designing MWP policies, separating low effort from low productivity may cancel out the negative impact on the hours worked of the population already in employment.

Estonia: Going Flat—An Avant Garde That Has Become a Common Practice

The transition of centrally planned economies (CPEs) to market-based ones in countries in transition (CITs) has affected every sector of the economy with varying degrees of success. Tax reform has been recognized as critical to the success of economic transition. Evidence suggests that the ability of CITs to reestablish economic growth or limit economic decline during transition has been contingent on the scope, speed, and stability of reforms (information in this section from Martinez-Vazquez and McNab, 2000; Ebrill and Havrylyshyn, 1999; Saavedra and others, 2007; Staehr, 2008; Funke, 2002; Funke and Strulik, 2006).

Most CPEs in Eastern Europe imitated the tax system of the Soviet Union in which tax revenues came mostly from profit, turnover, and payroll taxes levied on state-owned enterprises. The private sector was often outlawed and property taxes did not exist. Wage and payroll taxes were withheld at the enterprise level, with revenues generally earmarked to fund social expenditures. Taxation of individual income was relatively unimportant.

At the breakdown of the Soviet Union, the new independent countries had to enact their own tax laws and establish separate tax and customs administrations. Initially, the new countries simply adopted the Soviet tax system that had been modified to include VAT just days before the Soviet Union fell. Instead of handling the transactions of a highly controlled state sector, the new tax and customs administrations had to deal with more challenging compliance activities of both the emerging private sector and the increasingly autonomous state-owned firms. That shift entailed a new approach to tax policy and a different operational strategy for tax administration. Most of the countries of the Commonwealth of Independent States (CIS) that includes all countries of the former Soviet Union but the three Baltic countries have struggled to adapt to the change in the face of inadequate, declining revenues. The gravity of the situation had impelled the IMF to furnish and support adjustment programs such as the revenue action plans of 1997 that set forth reforms of tax policy and tax administration. The Baltic countries were spared from such programs as they rapidly implemented major revenue reforms at the outset of transition.

A number of countries in Europe and Central Asia have opted for a so-called flat income tax since the mid-1990s, with Estonia taking the lead in 1994. Flat income tax reforms vary from country to country, and none of them represents a literal flat tax on all sources of income. Some countries have implemented a flat rate only on the personal income tax (PIT), others have singled out corporate income tax (CIT), imposing a different rate level on it, and yet others have applied a flat (or proportional) rate at the same level to both PIT and CIT. The overall framework of personal income tax in Estonia has remained in place since 1994, although exemptions and rates have been altered on several occasions; a pension reform has changed the allocation of revenues from social taxes, adding a compulsory contribution for unemployment insurance.

Many countries have promoted investment and economic growth through generous tax allowances at the corporate level. Free capital movements, the EU's single currency, and information and communication technologies increase the mobility of tax bases. Greater exposure to international tax competition has put pressure on governments to lower taxes on mobile capital and shift the tax burden to immobile factors such as labor and domestic consumption.

Flat income tax can be defined as one that levies a flat rate (that is, a proportional rate) on all sources of income of individuals and businesses while avoiding double taxation. When it comes to PIT, this reform provides an alternative to progressive rates whereby higher income brackets are taxed at higher rates, with various exemptions and deductibles that reduce tax liability (the total amount of tax that an entity is legally obligated to pay to an authority). In the case of CIT, applying a single proportional rate to all kinds of businesses aims to lessen loopholes and exemptions that tend to build up over time. Such reform affects many aspects of an economy including revenue collection, tax compliance, administrative costs, economic efficiency, investment behavior, productivity, labor supply, and income distribution.

After five decades of Soviet rule, in 1991 Estonia regained independence. The nation inherited an inefficient planned economy and large macroeconomic imbalances. Within a decade, Estonia had established a well-functioning market economy and became a leading candidate for EU accession owing to rapid privatization of state companies, a currency board system introduced in 1992, liberal labor market policies, a free trade regime, and a new legal framework for private activity.

Most tax legislation was enacted during the first phase of transition, and for most of the 1990s, Estonia's tax system was stunningly simple. Enacted in 1994, Estonia's original tax code applied a flat tax rate of 26 percent to businesses, personal earnings, and capital gains, with depreciation allowances up to 40 percent for equipment and up to 8 percent for buildings. Additionally, there was a loss-carry-forward possibility over a period of five years, namely a tax provision paving the way for a company to reduce its tax liability by applying a net operating loss to previous years in which it made a profit. When companies paid dividends, they had to pay an additional tax of 26/74 (26 kroons for every 74 kroons) on net dividends, and shareholders received a dividend tax credit. The effect of this credit system was that distributed profits were only taxed at the shareholder's personal rate of income tax and not under a corporate tax.

Personal income tax was levied at a flat rate on taxable income exceeding the basic exemption and other personal tax exemptions. Taxable income comprised income from employment, business income of non-incorporated firms, pensions, interest receipts, rental income, etc. For most taxpayers, taxable income encompassed only labor income from employment or self-employment. A flat income tax rate had initially been set at 26 percent of taxable income in excess of exemptions (1994), but the rate was reduced to 24 percent effective from 2005 and has since been cut further. Indirect taxes in Estonia have been made up of a VAT and various excise duties. The VAT rate has been levied at 18 percent since 1994 with a lower rate of 5 percent levied on medicines, books, and newspapers. The government has imposed excise duties on alcohol, tobacco, energy, and packaging, as well as other taxes on enterprise income, land values, and gambling establishments. Estonia has not levied taxes on property other than land, gifts, inheritances, or wealth.

The 2000 income tax act had turned Estonia's income tax approach on its head and had wider implications for other nations that followed suit. From January 1, 2000, onward, companies have become subject to income tax solely with respect to distributions. Distributions include dividends and other profit distributions, fringe benefits, gifts, donations, representation expenses, and expenses and payments unrelated to business. The flat tax rate for all distributions has been 26/74 on net dividends. Under the new income tax legislation, corporate entities are exempt from income tax on undistributed profits regardless of whether they are reinvested or retained. The new corporate income tax has not constituted a tax exemption; taxation of profits has simply been contingent upon and awaited their distribution to individuals. Depreciation allowances have become redundant since there have been no taxes on corporate income per se.

A permanent establishment transferring assets to its head office or to other nonresidents has also been treated as distribution. Dividends paid to nonresidents have been liable to taxation at the general rate of 26 percent unless the nonresident legal entity has held at least 25 percent of the share capital of the distributing Estonian company. Capital gains realized by a resident corporate entity (including nonresident permanent establishments) have not been taxed prior to actual or hidden distribution, and have been subject to 26/74 income tax on a monthly basis. When it came to incorporated Estonian firms, capital gains have remained untaxed unless the receiver of capital gains has been an individual, in which case that individual has been liable for 26 percent tax on those gains.

The tax reform seemed to benefit the investment climate and fared quite favorably in the long run. Investment spending is affected by any number of things, notably the timing of the business cycle. When scrutinizing the Estonian investment share from the first quarter of 1993 to the fourth quarter of 2004, it has been apparent that the trend of investment share accelerated after 2000, while the investment ratio had started to abate in the late 1990s. Estonia has witnessed a fresh investment spurt, not least thanks to the tax reform act of 2000. Such empirical evidence tallies with various growth models, which demonstrate that lower taxation unambiguously boosts both investment and economic growth.

It is much harder to establish how changes in the capital income tax rate affect the well-being of households, since consumption and welfare depend on transitional dynamics and on whether the government holds constant its share of GDP, or whether efficiency gains from lower taxation are used to cut back government spending. Only in the latter case is the net welfare gain positive when transitional dynamics are taken into account. Growth literature indicates that lower taxation results in higher steady-state income, but there may well be only minute or even negative welfare gains if the shift involves large adjustment costs and high foregone consumption. Yet it has been found that the difference in tax systems across countries explains around 30 percent of variance in growth rates. Economists have long speculated that tax policy can affect economic growth, which falls in line with Estonia's 2000 corporate tax reform that has cultivated investment spending.

In international comparisons, the Estonian tax system is well known for applying flat rates and for its overall simplicity. However, personal labor income taxes along with social security taxes and taxes on consumption create a wedge between the costs of employing labor and the purchasing power attained by providing labor. This distortion of the relative price of labor affects labor supply and reduces welfare. Research that had estimated employment and welfare effects of personal labor income tax in Estonia asserted that individuals in the middle-income groups have exhibited higher elasticity in terms of labor participation than that of individuals in the low- and high-income groups. Assuming a utilitarian social welfare function, revenue-neutral tax reform to lessen the income tax burden on lower-income individuals but raise it on high-income individuals may lead to higher societal welfare. Welfare consequences have been nonetheless narrowly defined, overlooking administrative costs, compliance issues, and issues of political economy.

Saavedra and others (2007) focused on revenue effects of flat tax reforms that have become prevalent in Europe and Central Asia. Such reforms appear to have had positive effects on simplicity and compliance, as revenues have neither collapsed nor surged. Impacts have depended on the goals of the reform and its design features such as the tax rates imposed. When collections had dropped more than expected during the first year of implementation, they typically improved thereafter, reflecting either growth in the tax base or better compliance (or both). Oftentimes, reductions in real collections have been purposeful and manageable, having had positive implications for competitiveness and growth. A shift away from direct toward indirect taxes has been noticeable in most countries, taken prima facie as a conscious policy decision likely to boost economic growth.

Comparing Economy, Finance, and Taxation Systems across Nations

In this chapter we delved into the economies of some countries and taxation regimes and trends around the world. As the crisis that started in 2008 pervaded more and more countries and regions, its repercussions became ubiquitous. Europe was afflicted by the sovereign debt crisis soon after the U.S. subprime debacle, and it seemed no country was spared: “Following the collapse of the American investment bank Lehman Brothers, the financial system had gone into meltdown. Banks had been going bust all around the world. Trade had collapsed at a faster rate than at any time since the Great Depression of the 1930s. The great container ships that sailed from Shanghai to Rotterdam, laden with the mass-produced consumer goods that were the physical manifestation of globalization, were suddenly tethered empty to the docks.” (Lynn, 2011, p. 11) In the three Baltic countries whose transition was favorable, during the 2008–2009 global financial crisis, the externally financed domestic demand boom came to its abrupt end and triggered a severe output collapse that brought per capita income levels back to their 2005–2006 level (Purfield and Rosenberg, 2010).

The real protagonists of the crisis have nevertheless been the peripheral countries in the Eurozone known among economists as the “Club Med” countries: Portugal, Italy, Greece, and Spain (also referred to—unfortunately—as “PIGS”), all of which are southern European countries that developed very differently from the industrial powerhouses of northern Europe (Lynn, 2011, p. 59). Many scholars allege that the EMU should never have been born, as it was predicated on the assumption that upon acceptance to the Eurozone the new members would conform to the economic behavior of their (older-member) counterparts. The current crisis exemplifies that by applying “soft” accession rules in the corresponding treaties such as debt and deficit limits, one cannot undo years of history, erase consolidated cultural differences, or abolish entrenched institutional settings. Upon accession to the EU and the EMU, those nations, which conducted their economies prudently and efficiently beforehand (such as Germany), became even more prudent, whereas those nations that lagged behind embarked upon a spending feast under the aegis of the EU. No convergence had come about; instead, the Club Med countries had rather become more economically irresponsible and profligate as they suddenly had “cheap” money from the ECB in spades. The new countries in the EMU diverged economically from the old ones, having had pecuniary means to begin a spending spree. Spain has swollen a construction bubble while Greece tampered with figures to obscure severe ramifications of years of unscrupulous spending, an inefficient and cumbersome public sector, structural rigidities, and corruption.

One way or the other, private investors and taxpayers in the more prudent nations picked up the tab in the name of European solidarity, unity, and cohesion. It remains to be seen for how long hardworking citizens are willing to pull the Club Med countries out of the fire. Spain and Greece suffer from labor rigidities, underdeveloped human capital, low productivity, overall inefficiency, and lack of innovation and entrepreneurship. Those deeply embedded stumbling blocks are not likely to disappear soon; they are likely to persist, casting a shadow on economic growth. It became evident that pessimists were right to trumpet their Cassandra's prophecies; the members of the monetary union that is the leitmotif of this section had been from the outset too different in too many economic indicators (and in cultural respects)—it could not have succeeded. It has been tantamount to an older sibling bailing out his younger reckless brother again and again rather than a union of equals.

The Germans were fed up since 2013 was an election year, and by all recent accounts (e.g., The Economist proclaimed on October21, 2014that “the German economy is in a rut”) the locomotive of the EU is slowing down, handouts are bound to cease. The hardship facing the EU and the Eurozone in particular is not likely to go away anytime soon. Most researchers contend that the EMU should never have seen the light of day since states have lost their ability to formulate an independent monetary policy (see De Grauwe and Ji, 2012; Haidar, 2011; Neal and Garcia-Iglesias, 2012). Government bond markets in a monetary union are more fragile and more susceptible to self-fulfilling liquidity crises than stand-alone countries that both theoretically and empirically have proved to be immune from these liquidity crises and weathered the storm without increases in the spread (namely, without the interest on their bonds being on the increase in relation to German bonds). Reservations notwithstanding, once the union has been forged it is in the interests of all parties concerned that it remain intact, so markets do not lose confidence in the union as a whole and in the countries composing it (De Grauwe and Ji, 2012; Haidar, 2011; Neal and Garcia-Iglesias, 2012).

In 2010, Angela Merkel, the chancellor of Germany, spearheaded an effort to erect a permanent mechanism to assist other floundering EMU members, begetting the European Financial Stability Facility. Any aid rendered by that mechanism will by no means amount to what was handed over to the Greeks, who have almost bled the union dry. Any rescue plan in the Eurozone would be accompanied by tough fiscal conditionality in order to discourage other Eurozone members from misbehaving fiscally. As assistance is contingent upon rough austerity measures, Spain has avoided asking for a similar bailout package in light of the Greek hullabaloo (Haidar, 2011).

Iran is an example of a nation that has a lot going for it: a good geopolitical stand, human resources, and above all an abundance of hydrocarbon reserves. However, Iran is a quintessential example of the paradox of plenty, as consecutive Iranian governments opted for the facile revenues flowing from oil export but failed to heed other industries or enhance its human capital via investment in education, technological skills, health, and so forth. The Iranian economy has been subject to the whims of energy prices that are notoriously fluctuant. The money stream from oil that permeates the Iranian economy causes real appreciation and renders other industries less competitive internationally. As human capital is also wanting due to protracted government neglect, Iran lacks the underpinnings of sustainable growth. Over the years, Iran has preferred to hold onto its mass destruction weapons and nuclear plans while overlooking the repercussions of its conduct upon its citizens. Iran's geographic location as well as its natural and human resources has put it in an advantageous position to play the global game and seize opportunities for growth and development. Iran nonetheless adheres to its offensive international policies and retains its seclusion. Iran is less dependent on the West than half a century ago owing to its prominent Asian trading partners. Yet Iran is reliant upon trade, import, and export, so its population bears the consequences of its aggression. An unfriendly business environment in addition to underdeveloped human capital and infrastructure scare potential investors away, staving off the holy grail of foreign direct investment. Iran stands out blatantly in this respect, since most countries bend over backward to create a business-friendly environment in order to attract foreign investments in a highly competitive global market. Belgium and Denmark have been mentioned in this chapter as countries that undertook to lower labor costs so that multinationals and potential investors do not take their businesses elsewhere. By the same token, Estonia has pretty much reduced its corporate tax rate to 0 percent. Although many countries epitomize the “resource curse,” Iran seems to be sui generis in terms of its unrealized potential.

Romania exemplifies a nation that mounted the globalization wagon to reap the benefits of Europeanization. Unlike the Baltic countries, Romania has been bearing the harvest of its past communist, despotic past. Despite government action plans accompanied by financial assistance from government, private sector investments, and grants from the EU, it has been struggling to modernize its economy, and inter alia its salient agricultural sector. This substantive sector in terms of contribution to GDP, people employed, and poverty alleviation proved hard to reform when compared with quick structural adjustments in other transition economies. Indeed, it has tallied with painstaking transformations of the political system, the public administration, and various sectors of the economy that are still under way. A country's institutions can either facilitate or encumber transition and accession to the EU. In the agricultural sector, there had been positive signs in the past few years as Romania managed to alleviate poverty, including rural poverty, even if to a lesser extent (Salasan and Fritzsch, 2009).

Resource mobilization lies at the heart of economic development. Among various means of resource mobilization (such as forced savings, inflation tax, manipulation of terms of trade, and so forth), tax is closely related to questions of state formation and capability. Tax provides one of the principal lenses in measuring state capacity, power, and political settlements in a society. The determinants of tax collection and tax reform have been the subject of extensive analysis. Several theoretical approaches inform debates on two main issues. First, why does tax collection increase over time? Second, should the main concern be efficiency or equity when designing tax systems (Di John, 2006)? Estonia has clearly opted for the former rather than the latter when it inaugurated a flat income tax as early as 1994.

Tax reform has been a central part of World Bank and IMF operations in structural adjustment reforms in numerous transition economies (Di John, 2006; Ebrill and Havrylyshyn, 1999). Estonia waived progressivity and redistributive effects in favor of simplicity and efficiency. Owing to policy learning and diffusion of “neoliberal” ideas, policy makers learned that high tax rates combined with selective investment incentives are ineffective in the sense that they lead to inefficient allocation of resources, unfairness, and administrative complexity. Estonia's actions to reverse progressive income taxation, cut rates, and broaden the tax base while eliminating tax expenditures have all become part and parcel of the neoliberal economic orthodoxy such as the “Washington consensus.” (Ganghof, 2005; Owens, 2005; Swank, 2003)

Unlike many other countries in transition, Estonia's smooth transition did not entail a dire need of IMF or World Bank interventions because its history, culture, and viable modern institutions were in its favor. Estonia nonetheless did not stand still following its lustrous 1994 reform. At the outset of the current millennium, it launched a second tax reform to reinvigorate its flow of foreign direct investments. By doing so, Estonia managed to revamp its business environment with a new spurt of capital investments after the previous one, which had started at the beginning of the 1990s, receded.

In terms of compliance, efficiency, welfare gains, productivity, competitiveness, and revenue collections, Estonia's successful reform impelled many countries to follow suit, most of which are CIS countries (Commonwealth of Independent States, which had been Soviet Socialist Republics in the Soviet Union prior to its dissolution in December 1991), or former Soviet bloc countries. This attests to tax competition in the region and shows that people who suffered under communism are less susceptible to class-warfare rhetoric about “taxing the rich.” Thus far, Estonia has been a beacon inspiring similar flat tax reforms in countries such as Latvia, Lithuania, Russia, Serbia, Slovakia, Ukraine, Romania, Georgia, Iceland, Mongolia, Kyrgyzstan, Macedonia, Montenegro, Mauritius, Albania, the Czech Republic, and East Timor (Mitchell, 2007). It seems the last word has not been said yet, as proposals for flat tax reform continue to be paramount across the globe, though the matter is not so simple. Fuest and others (2008), for example, assert that flat tax reforms are unlikely to spill over to the grownup democracies of Western Europe; their simulations of a flat tax reform in Germany revealed very limited efficiency effects at best but problematic distributional impact.

Economic growth results from more factors of production, labor, and capital and higher productivity in the use of those factors of production. Since labor is an important economic input, ceteris paribus higher employment rates will lead to higher GDP. High taxes on labor nonetheless discourage both labor demand (by raising labor costs to employers) and labor supply (by lowering the real consumption wage of workers). They create a “tax wedge” between labor cost to the employer and the worker's take-home pay and thereby reduce both employment and economic growth (Rutkowski and Walewski, 2007). The main thrust of most tax reforms has been to increase GDP and hence growth by prompting unemployed and low earners into labor without pulling down the amount of working hours of the more productive high earners. Balancing those two countervailing tendencies may turn out to be almost impossible, as the point in which low earners and unemployed are boosted to work more without the high earners withdrawing and working less is very subtle and elusive. Estonia has managed to increase societal welfare; reducing the tax burden on low-income individuals spurred a substantial labor participation response and increased welfare amid them, whereas high-income individuals experienced only a modest reduction in employment and welfare (Staehr, 2008). Belgium, on the other hand, missed the delicate equilibrium point as the Jobkorting introduced by the Flemish government failed to increase general welfare and, a fortiori, the welfare of those whom it targeted: Joint assessment of income (for couples) for both purposes of taxation and benefit eligibility had unambiguous negative effects on the labor supply of secondary earners, mostly women. Furthermore, the increase in hours worked coming from new entrants was almost outweighed by reduction in the working effort of the population already in employment (Orsini, 2006). The tax credits were too modest to enhance low earners' employment efforts (Vanleenhove, 2011).

Another quandary stems from taxation of capital versus labor, since the size of income tax relative to other types of taxes (that is, the tax mix) may influence policy makers' ability to maintain high social expenditures (Kato, 2003, cited in Ganghof, 2005). On one hand, high taxation of labor may raise labor costs for employers and reduce employees' incentives to take on work; it may also compromise the economy's competitiveness in the international arena. On the other hand, taxing capital too highly is very risky in the age of footloose capital that moves quickly and freely across borders and continents. Nations strive to attract as much foreign direct investment as they can and to keep capital and industries at home. One way to realize that is to provide a healthy, educated, and innovative workforce, so governments should invest in their citizens' human capital. A complementary measure is a favorable, business-friendly environment such as low taxes on capital and investment revenues. Estonia resolved this dilemma via an elegant design of taxation whereby personal income is taxed at a flat rate regardless of origin, be it labor, rent, dividends, etc. Consolidating income from all sources gave rise to an efficient and simple system that many countries endeavored to replicate (Funke, 2002; Funke and Strulik, 2006; Staehr, 2008). A 0 percent rate of corporate tax (since profits, whether retained or reinvested, are not taxed prior to distribution) induces a favorable environment for investment and capital that most countries can only dream about (Funke and Strulik, 2006). Belgium is almost an antipode of Estonia as it espoused a multilayered, intricate tax reform comprising many components, some of which have been at odds. Belgium embarked on a long process to lessen harmful labor-market effects of high labor income tax to make the country a more attractive site for direct investment and for multinational enterprises to declare their profits (Carey, 2003), with partial success.

Denmark has also been engaged in a lot of trial and error, giving rise to a patchwork quilt tax system, quite the opposite of the simple Estonian one. Denmark phased in tax reform between 1994 and 1998 that rendered it the first Nordic nation to move away from global income tax, wherein a single progressive tax schedule is applied to the sum of the taxpayer's income from all sources, toward a system of so-called dual income taxation, wherein taxation of capital income is separated from that of other sources of income. As opposed to traditional bureaucratic “command and control” methods, Denmark ventured to use environmental taxation as an economic or market-based instrument for environmental regulation, hoping not only to abate pollution but also to reduce labor costs and taper unemployment. Denmark has imposed energy taxes on electricity, oil, and gas. Those were highly criticized, since they have been paid not only by lax, profligate users, but also by stringent users, which casts doubt on their ability to induce frugality and thrift with respect to energy use. Like Belgium, Denmark has used energy taxes to generate new public revenues that would enable a general reduction of top and bottom levels of income taxes, rewarding the contribution of top earners better while boosting low-income employment (Kloka and others, 2006). Fearing that lower labor costs would be offset by loss of international competitiveness that would arise with a unilateral increase in the price of energy in Denmark, a fair share was earmarked as direct subsidies for energy conservation projects, decentralized power/heat generation, and biofuels. A further large share went to investment subsidies aimed at completing the countrywide system of district heating. It is impossible to gauge the impacts of the Danish reform due to its complexity and the fact that growth and employment are contingent upon many factors that are impossible to extricate, such as the global business cycle, energy crises, and so on. Denmark resorted to a “fat tax” in pursuit of a healthier population, making healthier nutritional choices, and enjoying greater longevity. The tax has been short lived and withered on the vine. It was cumbersome bureaucratically and expensive and failed to yield desired outcomes as frustrated Danes went to buy the “forbidden goods” in neighboring countries. Food producers had no incentive to produce leaner food products since the proportion of fat was estimated roughly—not measured and calculated exactly for each and every product. Barely a year into implementation at the end of 2012, the Danish parliament rescinded the fat tax. When the fat tax was obliterated, the tax ministry also renounced its intention to introduce a sugar tax, grasping that it takes more than a tax to subjugate a craving for fat and sugar and that such taxes may rather trammel Danish industry and competitiveness, which may raise unemployment (Stafford, 2012). At the end of the day, both Danish and Belgian policy makers had to come to terms with the fact that quite often, people will not readily change their behavior and preferences, so simple pecuniary measures will not do: Low earners with poor human capital are unlikely to rush into the labor market.

Taxation will remain a tall order as governments struggle to juxtapose employment with welfare, to counterbalance a friendly environment for capital with favorable conditions for employers and employees, and to inspire desired behavior without hampering competitiveness but paying heed to equity and societal cohesion.

When it comes to economy, taxation, and government expenditures as opposed to revenues, humanity has been vacillating since ancient times. The distribution of national wealth is an issue of only the past 150 to 200 years or so, while the redistribution of international wealth is of even more recent origin. In the near future, those issues will continue to loom large mainly with respect to the current global crisis; it looks as if the world is not out of the woods yet.