Tag: Economic reforms

Incomes of Polish Households in the Context of 2005-2011 Tax and Benefit Reforms: A Pre-Election Analysis

Policy Brief Image of a Man and Polish Household Representative with Polish Flags Days Before Government Elections

On October 9, Polish voters will decide who will form the new government. In an analysis of tax and benefit reforms introduced over the last two terms of Parliament, the independent Centre for Economic Analysis, CenEA, examines who gained and who lost on the implemented changes. The reforms that have been implemented since 2006 include significant tax reductions and important changes to family benefits, as well as a recent increase in the VAT. In the context of declarations made in earlier electoral campaigns, the actually implemented economic policies introduced, offer little guidance to the voters regarding the reliability of promises made during this current campaign.

The last two terms of office for the Polish parliament includes the period October 2005 till November 2007, and the current four-year term which followed a snap-election in 2007, and which will now come to an end with parliamentary elections scheduled for October 9.

During 2005-2007, the ruling coalition was led by the Law and Justice party (PiS) who then lost the 2007 elections to the Civic Platform (PO). This year, these two parties remain the main contenders for electoral victory.

The years since 2005 have been marked by a series of significant reforms with substantial influence on disposable incomes of Polish households. These reforms are analyzed in the first Pre-election Report recently published by the independent Centre for Economic Analysis, CenEA (Myck et al., 2011). This report analyses the extent of the most important economic reforms undertaken in the last two terms of office and their distributional consequences. The analysis is done using the Polish microsimulation model SIMPL based on a dataset from the Polish Household Budgets’ Survey.

The report considers the following economic reforms:

  1. reductions in disability rates of social security contributions (SSC) in 2007 and 2008,
  2. introduction of a generous child tax credit (CTC) in the personal income tax system in 2007,
  3. introduction of a two-rate (18% and 32%) instead of a three-rate (19%, 30%, 40%) system of personal taxation (PIT reform) in 2009,
  4. a series of reforms to the means-tested system of family benefits (FB) in 2006 and 2009,
  5. a VAT reform which increased the basic rate from 22% to 23% and changed the operation of lower rates at 5% and 8% instead of 3% and 7%.
Table 1. Effect of changes in Social Security Contributions, Personal Income Tax and Health Insurance on the balance of public finance in tax systems from 2005-2011 (year to year changes, in million euro)

Source: based on Myck et al. (2011), Table 4.
Annual values are given in Euros; differences in SSCs are computed as net changes accounting for changes in the public sector’s employer contributions. Exchange rate: 1 Euro = 4.3595 PLN.

While the big reforms grabbed the headlines, subsequent governments which oversaw their implementation, followed the policy of raising taxes and lowering expenditures through policies of freezing the value of tax credits and eligibility thresholds for family benefits. In the latter case, this generated a reduction in the number of children eligible to family benefits by 18%. At the same time, the value of benefits to those receiving them increased, on average, by 60%, with the net effect being a 7% increase in family benefit spending.

It is shown in our report that the reform package implemented in the 5th term of Parliament, and which included, in particular, the SSC reforms (2007/08), the CTC (2007), and a reform of the FB system (2006), has been distributed very evenly across different income groups. Households in income deciles 1-9 saw their incomes grow by about 4.5%, while those in the top decile gained about 3%. The implementation of the tax reform in 2009 brought about significant gains only to high income households. This tax reform was legislated prior to the financial crisis in 2008. The policy of freezing tax credits and benefit-eligibility thresholds, introduced in 2008 and 2011, resulted in losses for middle-income groups but meant that the bottom decile gained about 1%. This was largely through changes in the value of family benefits for families receiving them.

The entire 2006-2011 package of tax and benefit reforms, had a direct impact on households’ incomes since it increased real disposable incomes, on average, by 5.4%. Here, the households in the top income decile gained the most (9.2%). The lowest gains were found in the 3rd decile (3.4%). Moreover, the poorest 10% of households gained, on average, 5.7% from the introduction of the entire package.
The nature of these reforms had an interesting distribution in terms of age and family type with the highest gains going to working-age individuals, in particular to married couples with children (10.2%). On the other hand, single pension-age individuals saw their income fall slightly as a result of the reforms (-0.3%), and only small gains have been seen for pensioner couples (0.5%).

In the report, we set the implemented policies against promises and declarations made by the principal parties during electoral campaigns and government goals declared in the Prime Ministers’ exposé’s.

Out of the main policies implemented by the 2005-07 government, only the PIT reform of 2009 has been introduced in a form declared in the 2005 PiS electoral program. Its introduction was, however, legislated for 2009 and fell therefore under the current term of office. The introduced reductions in the rates of the SSC, one of the most costly reforms, were not mentioned in the electoral pledges.

Moreover, the declared form of the CTC in the electoral program of PiS, was very different from the one introduced in 2007. The introduced program centered on the theme of a “solidarity package”, whereas the declared CTC was to be focused on low-income families. The introduced policy, about 9 times as expensive as the declared one, transferred resources to low-income families but was most generous to high earners who pay enough tax to take advantage of the generous maximum amounts of the credit. The generosity of the CTC makes it the most costly “tax expenditure” item in the Polish system of direct taxes, with a value of 0.4% of GDP (Finance Ministry, 2010).

In terms of the PO’s program and the Prime Minister Tusk’s exposé’s, the report analyzes the focus on further reduction of taxes. In the midst of the financial crisis, the current coalition oversaw the introduction of the 2009 PIT reduction but withdrew from implementing a 15% flat tax, one of its flagship policies prior to 2007. However, despite a reduction in the basic rate of tax from 19% to 18%, income taxes grew on average among low and middle-income households (1-6th decile) because of the freezing of the tax credits. The net effect of income tax policies, in the current term of office, has meant gains for higher income households, with a substantial reduction in income taxes for those in the top decile group (on average 23%).

In light of the growing level of public debt, the current government implemented a VAT reform that raised indirect taxes by about 0.3% of GDP. The combination of an increased basic rate, with a reduction of lower rates on main food items, produced a proportional distribution of the tax burden.

Overall, the tax record of the current government is mixed. The implemented reductions were legislated already prior to its arrival, and the net result of the packages implemented in recent years hangs importantly on the level of households’ income. On average, only the top three deciles of households have seen their tax burden fall.

Each of the coalitions have their excuses for failing to deliver the promised policies. For the 2005-07 coalition, it is the early dissolution of Parliament. The current government, led by the Civic Platform, had to maneuver through the difficult years of the financial crisis and an economic slowdown. At the same time, one could interpret the policies implemented in the first two years of the 2005-07 Parliament as an expression of policy priorities, whereas the policies implemented during the current Parliament, can be confronted with their previous declarations to examine which groups of society they have prioritized.

In Poland, household income has grown fast in recent years. On the one hand, due to growing wages and earnings, on the other, due to introduced packages of tax and benefit reforms. Despite the financial crisis, the Polish economy has so far performed relatively well.

The reforms implemented in the last two terms of office, offer however little guidance to the credibility of electoral declarations on socio-economic policy. Even though the Law and Justice party (PiS), the leading party of the 2005-2007 government, legislated one of its key promises while in office (the PIT 2009 reform), it also implemented substantial reforms which were either not originally in their electoral program, or which took a very different shape and benefited other segments of the population. Even if the current government withdrew from the promises of further tax reductions when faced with the challenges of the financial crisis, it oversaw the implementation of significant tax cuts legislated in the 5th term of Parliament. Overall, however, the implemented policies increased taxes of lower income households.

To conclude, our results suggest that if Polish voters’ decisions are to be guided by declarations in the area of socio-economic policy, they will face a tricky choice on the 9th of October.

Figure 1. Changes in disposable incomes of Polish households as a result of tax and benefit policies implemented between 2006 and 2011, by income deciles.

Source: CenEA, Myck et al. (2011). Notes: average monthly values per household in a given decile group.

References

  • Finance Ministry (2010) “Tax Expenditures in Poland”, Polish Finance Ministry, Warsaw.
  • Morawski, L., and Myck, M. (2010) “‘Klin’-ing up: Effects of Polish Tax Reforms on Those In and on those Out”, Labour Economics, 17(3), str.556-566.
  • Myck, M., Morawski, L., Domitrz, A., Semeniuk, A. (2011) „Raport Przedwyborczy CenEA, część I. 2006-2011: kto zyskał, a kto stracił?” (CenEA’s pre-election report: 2006-2011 who gained and who lost? ), Microsimulation Report 01/11, Centre for Economic Analysis, Szczecin.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

What Does Modern Political Economics Tell Us About the Fate of Russia’s Reforms?

20110905 Policy Brief Image Russia Kremlin Saint Basil Cathedral

After the 2008-09 crisis, Russia is facing a new set of challenges. The pre-crisis sources of growth have been exhausted. In order to implement its growth potential and catch up with OECD countries, Russia must improve its investment and business climate. Although the reform agenda has been repeatedly discussed, it is not being implemented. The explanation is provided by modern political economics: what is good policy (in terms of social welfare and growth) is not necessarily good politics (for a country’s rulers). In this sense, modern Russia is a perfect example of the non-existence of a political Coase theorem. Although everybody understands that the status quo is suboptimal, the most likely outcome is further postponement of reforms.

Whither Russia?

In 2009, the New Economic School joined the Russia Balance Sheet project launched by two DC-based think tanks: the Center for Strategic and International Studies and the Peterson Institute for International Economics. The aim of the project was to assess Russia’s assets and liabilities. Similarly to compiling a company’s balance sheet, the project estimated the potential for long-term development and growth, and the problems that could prevent Russia from realizing this potential.

The main output of the project in 2009-10 was the book “Russia after the Global Economic Crisis”, which was published in English in the Spring 2010 and in Russian in the fall of the same year. The book looked at a broad range of issues that could be classified as Russia’s “assets” and “liabilities”, extending from economic, political and social issues to energy, foreign relations, climate change, innovation and military reform. Interestingly, despite the breadth of the analysis, the authors of the book’s different chapters arrived at similar conclusions, which might be summarized as follows: while Russia came out of the crisis in a reasonably good shape and has nothing to fear in the near term, it has serious long-term problems that need to be addressed as soon as possible; however, it is, unfortunately, the case that Russia is unlikely to implement the required reforms, since they go against the interests of the ruling elite.

This argument is especially clear with respect to Russia’s economic problems – that Aleh Tsyvinski and I analyzed in the first chapter of the book. In the short run the Russian economy is certainly doing quite well. So long as oil prices stay high, the budget remains balanced, the economy grows, and sovereign debt is virtually non-existent (in marked contrast with debt burdens of OECD countries). Contrary to what is claimed by many critics of the government, pre-crisis growth did trickle down to all parts of Russian society, and that has ensured that the government enjoys sufficient political support.

However, in the long run, the situation is very different. The pre-crisis sources of economic growth (rising oil prices, low capacity utilization and an underemployed labor force) have all been exhausted. Oil prices are high, but are unlikely to rise much further. Production capacity and infrastructure are over-utilized. The labor market is very tight. In order to grow at the rates, which Korea and other fast-growing countries achieved when they were at Russia’s level of development, Russia needs new investment. Hence, Russia has to improve the business climate and the investment climate. This, in turn, depends on reducing corruption, improving protection of property rights, building an effective and independent judiciary, and opening the economy to competition (both domestic and international).

Good Policy, Bad Policy

The changes that are needed in order to ensure strong growth are obvious, but they are unlikely to happen. The reason is very simple: the political equilibrium is such that Russia’s political elite is not interested in change. There is nothing unusual about this. As Bueno de Mesquita et al. (2003) have argued: good policy may be bad politics and vice versa. If achievement of economic growth depends on surrendering control over the commanding heights of the economy (through privatization, strengthening the rule of law, deregulation, and encouragement of competition), the ruling elite may fear a weakening of its hold on power and ultimate loss of power as the price of achieving growth. In this case, the ruling elite will prefer to stay in charge of a stagnating economy (and enjoy a big piece of a small cake) rather than risk losing power (and having no piece of a bigger cake).

Can society somehow buy out the vested interests of the rulers? One of the most powerful theoretical results in economics, the Coase theorem, would suggest that the answer is yes. However, the conditions of the Coase theorem are not met in the instance of political economy, which we are considering. In our case the ruling elite does not merely trade goods or even assets: by allowing reforms it would lose the power to expropriate and protection from being expropriated. Unsurprisingly, there is no “political Coase theorem” (see Acemoglu, 2003).

As we discuss in Guriev et al. (2009), this problem is particularly acute in resource-rich transition economies without established political and legal institutions. In such economies, the lack of institutions means that the rulers are less accountable and can therefore appropriate a large share of the resource rents. The resource rents increase the incentives to hold on to power and provide the rulers with the resources which they need in order to maintain the status quo.

In the opening chapter of “Russia After the Global Economic Crisis”, Aleh Tsyvinski and myself argued that this is precisely Russia’s problem. We punningly defined the status quo as a “70-80 scenario”: if the oil price stayed fairly high ($70-80 per barrel) then Russia would be likely to follow the 1970-80s experience of the Soviet Union, when reforms were shelved and the economy stagnated. That period ended with the bankruptcy and disintegration of the Soviet Union.

Certainly, the differences between modern Russia and the 1970-80s Soviet Union are substantial. Although the government controls the commanding heights of the modern Russian economy, the nature of the latter is capitalist and not command. Also, Russian economic policymakers are much more competent and, unlike their Soviet predecessors, they can easily believe that if a country runs out of cash, the government is removed from office: they have seen it happen to those same Soviet predecessors.

This brings us to a conundrum: if it is clear that the status quo is a dead-end, what is the ruling elite hoping for? On the one hand, the elite understands all too well that reforms are risky – everybody remembers the last Soviet government, which initiated change and lost power as a result of that change. On the other hand, it is clear that in order to remain in power the government needs growth and that growth can only come from reforms.

Rational Overconfidence

The solution to this conundrum is to be found, not in modern political economics, but in the realm of behavioral economics and studies of leadership. In recent years, economists have been keen to integrate insights from psychology into their models of markets and organizations.

Psychologists know very well that human beings want to be happy, and are therefore disposed to forget bad news and remember only good news. They also like to persuade themselves that they are good (or at least better than others). This explains why investors always want to believe in more optimistic scenarios (hence bubbles, see Akerlof and Shiller, 2009). Furthermore, a certain degree of over-optimism on the part of leaders is actually “rational” or “optimal” (see Van den Steen, 2005, and Guriev and Suvorov, 2010). Over-optimistic leaders are more resolute, and they attract more capable and enthusiastic followers. In this sense, in an environment with weak political institutions, over-optimistic political leaders always crowd out more realistic leaders (who do not promise as much). Where there are strong political institutions that ensure political accountability (e.g. via political parties), this behavior is not sustainable. But if there is no accountability, over-optimism almost inevitably prevails as a result of political selection.

This may explain why the Russian political leadership hopes for the better. So far the model “whenever we are in trouble, the oil price goes up and saves us” has worked, and it will keep working until the oil price goes down and undermines both macroeconomic and political stability. Once again, resource abundance is important as it helps to feed the over-optimism: the fortunate leaders that rule during the period of high oil prices can easily believe that their luck is permanent and their belief (or, as the leadership literature calls it, “vision”) will be consistent with the evidence – but only until the oil price plunge.

The 70-80 Scenario: Two Years On

We started to write the 70-80 chapter in the fall of 2009, when the oil price was already back from $40 per barrel to the fiscally comfortable range of $70-80 dollars. What has happened since then to the likelihood and sustainability of our scenario?

What we find is that, although the 70-80 pun no longer works, our main argument has been reinforced. First, the oil price is no longer in the range of $70-80 per barrel, but has risen higher due to events in the Middle East and Japan, as well as increased demand for oil as a store of value reflecting diminished confidence in dollar and euro assets. Second, the Arab Spring has made the Russian government suspect that its hold on power is more tenuous than it previously believed, and it has started to spend even more aggressively. Russia’s budget is no longer in surplus at $70 per barrel: it can now only be balanced if the oil price is at $125 per barrel (!). In this sense, $70-80 per barrel is no longer a “high” price – it is both below the current market’s expectations and below the Russian government’s fiscal benchmarks.

However, our main argument has been reconfirmed. High oil prices have encouraged the Russian government to become further entrenched in the status quo scenario. While there has been a substantial increase in rhetoric about privatization, deregulation, competition, rule of law etc., actual change has been lacking. On the contrary, there is increasing reliance on government ownership and increasing probability that Russia will move further down the road to stagnation after the presidential elections of 2012.

Can There Be An Alternative to Stagnation?

In “Russia After the Global Economic Crisis” we also charted an alternative scenario based on reforms that help to realize Russia’s substantial growth potential. Is this scenario feasible? Certainly, the laws of political economy are not deterministic. Even though the status quo path is preferable for the country’s rulers, a leader (or a sub-group in the elite) may emerge who is long-term-oriented and is not over-optimistic. If this leader or group manages to create a critical mass of stakeholders for reforms, there may be a “run” on the status quo. For example, if the oil price decreases and there is fiscal pressure to privatize, then a critical mass of private owners may emerge who are interested in protection of property rights and the rule-of-law.

However, even though a positive scenario is possible, it is not very likely. Investors have already reached this conclusion: Russia has been experiencing large capital flight since the fall of 2010 (net capital outflow is about of 5% of GDP). Investors are not yet ready to bet their money on the good scenario. Nor would political economists recommend them to do so.

References

  • Acemoglu, Daron (2003). “Why Not A Political Coase Theorem? Social Conflict, Commitment, And Politics,” Journal of Comparative Economics, 31: 620-652.
  • Akerlof, George A., and Robert J. Shiller (2009). “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism”. Princeton University Press.
  • Åslund, Anders, Sergei Guriev and Andrew Kuchins (2010). Russia after the Global Economic Crisis. Peterson Institute for International Economics. Washington, D.C.
  • Bueno de Mesquita, Bruce, Alastair Smith, Randolph M. Siverson, and James D. Morrow (2003). “Logic of Political Survival”. MIT Press.
  • Gilbert, Daniel (2006). “Stumbling on Happiness”. Knopf.
  • Guriev, Sergei, Alexander Plekhanov, and Konstantin Sonin (2009). “Development Based on Commodity Revenues.” European Bank for Reconstruction and Development Working Paper No. 108. Available at SSRN: http://ssrn.com/abstract=1520630 (Also available as Chapter 4 in the Transition Report 2009).
  • Guriev, Sergei, and Anton Suvorov (2010). “Why Less Informed Managers May Be Better Leaders.” Available at SSRN: http://ssrn.com/abstract=1596673
  • Van den Steen, Eric J. (2005). “Organizational Beliefs and Managerial Vision.” Journal of Law, Economics, and Organization, 21: 256-283.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.