Political Economy of Tax Reforms in Central and Eastern Europe: Three Emerging Conflicts Since the Crisis

Why countries scrap flat taxation? Many studies explain why states adopt single-rate (flat) tax policies, but there is very little – if anything – known why and how such apparently successful flat tax systems erode. Before the crisis, tax systems in Central and Eastern Europe (CEE), driven by international factors, such as tax competition and international organizations, converged towards flat tax systems. However, since the crisis, CEE-10 tax policy has radically shifted from the pre-crisis established policy path, and has mostly been driven by domestic factors. In distributional terms, the post-crisis policy change takes place across three divides. First, distribution by class occurs via increasing PIT progressiveness (hikes at the top vs. expenditures at the bottom). Second, distribution by origin takes place in novel sectoral taxes on foreign-owned capital (e.g. banks, utilities, telecoms etc). Third, distribution by size – an emerging conflict between larger and smaller businesses – takes place via special PIT and SSC treatment for micro-companies and the self-employed. The three trends challenge the common wisdom that in CEE dependent market economies tax policy, void of domestic politics, is mostly shaped by international tax competition. The paper argues that under the conditions when foreign investors become reluctant and investment cannot be taken for granted anymore, the role of domestic actors increases. The three-pronged policy change across the region then is a result of tax base erosion that operates through unemployment and shadow economy, on the one hand, and fiscal urgency, on the other. First, concerns over legal employment force governments to introduce progressive expenditures for most evasive and unemployment-prone workers and/or small businesses (the self-employed). Second, fiscal urgency results in tax hikes on high-earners or most profitable immobile capital. This two-step model is tested against major post-2008 tax reforms that correspond to the specified distributional criteria (class, origin, size). The paper speaks to two literatures. First, providing a post-crisis update of political economy literature on CEE taxation and capitalist regimes, it argues that the crisis shifted the locus of tax politics from international to domestic arena. Second, speaking to the literature on (determinants of) tax reforms, the CEE-10 shows that during the crisis the main reform drivers were domestic politics and economics, whereas the role of international actors and external bailout conditionality remained marginal.