Flat Tax Systems and Populism

After the turn of the millennium, the race to win international investors and the debate on neoliberal reform led to a transnational discussion of flat tax rates. The Baltic states were the first to introduce an identical tax rate on all incomes, private and corporate. Initially this was set at between 25 and 33 percent, varying from country to country. This was not far below the average level of taxation in the Western European welfare states.3 The goal was a simplified tax system without scope for deductions or exemptions, to make it easier to collect tax. Other countries soon adopted, and radicalized, the flat tax arrangement. Russia, Ukraine, and Serbia set their rates of taxation at 13 or 14 percent, albeit with some exceptions.4 Cultural factors were an additional motivation for these countries’ policymakers. They had no illusions about the tax ethics of their citizens, especially the nouveau riche. But they hoped that if they set tax rates low, they might at least accept and pay them. In 2004, Slovakia followed suit with a flat tax rate of 19 percent for private and corporate income tax and value-added tax. Slovakia’s tax reform caused a particular sensation as it coincided with the expansion of the European Union. Neoliberalism was no longer on the horizon; it had arrived in the EU.

The trend toward flat tax rates evolved in parallel with the aforementioned radicalization of privatization. In the early nineties, governments had privatized retail trade, the catering sector, and craft industries in the relatively quick and successful process of “small privatization.” The sale of large enterprises proved far more difficult and resulted in losses, but it also progressed. By the mid-nineties, governments were selling companies responsible for public services and utilities such as postal and telephone services, power, and housing. A few years later, this trend reached Germany and eventually all of the core EU countries.

Around the turn of the millennium, privatization entered into a third stage, targeting key state responsibilities such as old-age pensions and health care. Again, the Baltic states blazed a trail. Hungary, Poland, Slovakia, and—somewhat half-heartedly—the now Social Democrat–ruled Czech Republic followed. While each country’s welfare reforms differed in detail, the debates attending them were similar. Commentators criticized state pension and health care systems as antiquated, inefficient, and not viable in the long term, and commended the private sector alternatives as advanced, rational, and sustainable. This discourse was conducted in parallel to, and fuelled, the privatization process. Private pension funds and health-insurance schemes were promoted as a customized way of providing for one’s old age, rather than paying into an anonymous social security system or ailing national budget. Private insurance schemes promised greater fairness by taking individual contributors’ payments and risks into account when setting fees, rather than charging progressively, according to income. The fact that this was bound to cause redistribution from the bottom up ruffled few feathers. Some political parties—such as the German Christian Democrats in Leipzig in 2003, considered in chapter 9—even used it as an argument in favor of further welfare reforms. From a historian’s viewpoint, this third stage of privatization is the most problematic. Indeed, it had unintended effects, and was reversed in most postcommunist countries after the crisis of 2008.

The redistributive effect was particularly pronounced, and welcomed, in countries that had adopted flat tax systems. Governments made good the losses incurred by tax increases—euphemistically referred to as fiscal simplification—in other areas. Slovakia, for instance, raised its value-added tax on foodstuffs and other staple goods to 19 percent, in line with income tax. The result: price increases of 5 percent and more and drastically reduced social benefits. The proportion of welfare spending in the gross domestic product dropped from 19.5 to 16 percent, almost the same level as in the Baltic states.5 This hit the country’s many Roma especially badly. In early 2004, they rioted for some days in eastern Slovakia, looting stores and attacking government institutions. But the protests were soon quashed. The Roma alone were held responsible for their problems.

Did these neoliberal measures have a macroeconomic effect? Foreign investment in Slovakia and the Baltic states increased markedly. Today Slovakia produces more cars per capita—in new factories—than any other country in the world. In Russia and Ukraine, by contrast, the flat tax system did not sustainably boost the economy or attract more investment. Countries that eschewed such tax reforms, such as Poland, experienced just as dynamic growth as Slovakia while developments in flat tax countries—Estonia and Lithuania, for example—diverged. Neither the results of these measures nor those of the shock therapy, then, point to a clear causal connection between certain fiscal and social policies and economic development.

The flat tax systems certainly had one effect: they raised international experts’ and investors’ awareness of these countries. Consequently, Estonia, Latvia, and Slovakia, to name a few, climbed the international rankings, and were even referred to as European “tiger economies” (together with the “Celtic tiger” on the Western fringe of the continent). With their high growth rates and low taxes and wages, the “Baltic tigers,” “Slovak tiger,” and “Slovenian tiger” (although Slovenia pursued a different macroeconomic policy) caused quite a stir.6 Associating them with the growth economies of the Far East (the “East Asian tigers”) was a promotional coup. Small Eastern European countries now appeared in the financial world’s indices alongside South Korea and Taiwan, countries with far larger economies and populations.

Behind these positive headlines, social tensions were rising massively in all postcommunist countries. From the mid or late nineties, the rate of combines going bankrupt or laying off staff accelerated. Millions of people lost their jobs as one factory after the next closed down. The unemployed had few financial reserves to draw on; their savings had been largely devalued by high rates of inflation in 1989–90 or later. (The timing and rates of inflation varied from country to country; the former GDR and the Czech Republic were less severely affected.) Legions of pensioners were in need of assistance. There were very many potential recipients of social benefits—a factor only insufficiently considered by the architects of the shock therapy—but few potential contributors.

The imbalance was most pronounced in the Baltic countries, which had afforded minimal state pensions and social benefits from the outset. The ruling elites refused to raise welfare spending even when the economy had recovered, partly on account of the large national minorities in the region. Many losers of the reforms were resident Russians (some of whom were in fact Ukrainian or Belarus). The Baltic governments objected to supporting their countries’ former occupiers with social benefits. After voting out the postcommunists in the mid-nineties, Romania and Bulgaria also introduced neoliberal reforms.

A side effect of these reforms was very low election turnouts in the postcommunist countries. In the early nineties and during the second wave of neoliberalism, many citizens evidently felt they had so little influence on politics that there was no point in voting. Deficient democracy and neoliberal reform policies were, then, mutually dependent.7

Under these conditions, a new political trend emerged: populism. The populists’ simple strategy was to focus entirely on the nation, disregard the opinions of international investors, and, above all, promise the ethnically defined electorate protection against the rigors of transformation. They pledged to safeguard the populace from financial competition and criminality, and to protect their jobs and national values. Their allure tended to fade, however, once they were voted into government, and found themselves cooperating on unpopular reforms and forced to communicate with external actors. Due to the unpopularity of neoliberal reforms, governments were often voted out after just one term. The same has occurred in recent years to the reformers in Southern Europe. Despite vacillating voters, who caused the complete downfall of some ruling parties (one extreme example is the Akcja Wyborcza Solidarność, which emerged the clear victor in 1997 but failed to win any seats four years later), and the success of populist parties, the new EU member states are generally regarded as “consolidated democracies.” (Hungary is a special case, considered below.)8

German transformation expert Wolfgang Merkel has stressed the contribution of longer-term factors, such as the stability of governmental structures and the high level of education among the population, to the success of reforms in postcommunist countries. His conclusion conflicts with the Chicago School’s rejection of big government and the contempt for all legacies of state socialism that prevailed in the early nineties. After the fall of the Iron Curtain, virtually all forms of state interventionism were condemned as outdated. Yet some government investments turned out to be vital. One example is the postwar expansion of public education that had started earlier, and was more sweeping, in Eastern than in Western Europe.9 Thus the state-socialist countries had accumulated a major resource that was useful for transformation: human capital.

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