Eastern and Central Europe
– Second Wave of Reform and Success

By Nima Sanandaji 

Two decades ago a wave of democratic freedom swept over Europe. One by one the communist dictatorships in the East could change into market economic democracies. Since then the nations in Eastern Europe and the Baltic have come to play an increasingly important role in the European community; as business partners and as members of the European Union. Over time
they have also grown in importance as international competitors. The countries have not only reformed away from planned economy, but they have also adopted the market economy in a clearer way than their Western European neighbors. Several of the
states in Eastern Europe and the Baltics have been characterized by their good conditions for entrepreneurship combined with low- and flat tax rates.

Prior to the ongoing economic recession, a central issue was how the western tax systems would be able to compete in the long run with the quickly growing economies in the East – where the taxes for labor, business and capital are significantly lower than in the West. How can, for example nations such as Denmark, Sweden, Belgium, the Netherlands, Austria and Finland – where the
highest marginal tax rate on labor is at or above 50 percent – compete with the Czech Republicand Slovakia where the tax is flat at 15 and 19 percent respectively?

However, the discussion about Eastern Europe and the Baltics has turned rapidly in response to the financial crisis. Today, media primarily directs the spotlight on how hard these countries have been hit by the crisis, especially above all Latvia and Ukraine. This is an important issue, but at the same time we should not lose focus on the long term competitiveness and growth potential in
Europe’s new market economies. The countries in Eastern Europe and the Baltics have shown a phenomenal ability to turn a
decline into growth and development during the last two decades. The entire region was hit by an enormous shock when the communist planned economies fell overnight. But not least the countries that were quick to reform such as Poland, the Czech Republic, Slovenia and Estonia have been able to recapture a strong prosperity development since the fall of communism.
This prosperity development has, as opposed to the prediction of the reform critics, been accompanied by a rapid decline in poverty, increased income for the elderly and increased investments in social care. Nations such as the Czech Republic, Hungary and Slovakia are characterized by having amongst the lowest rates of relative poverty in Europe.

Latvia and Lithuania succeeded to recover and grow despite the fact that their economies had decreased by half from 1991 to 1993. We have good reason to believe that Europe’s new market economies once again will grow rapidly when the present recession is turned into a time of prosperity. This regards not least the regions greatest economies, Poland and the Czech
Republic, that have passed through the crisis well so far. The recession does not only represent a financial crisis, but also an ongoing globalization process. Many industries in the Western World are forced to downsize or to declare bankruptcy because
they cannot handle the increased global competition from the new market economies, such as India, China and the Eastern European and Baltic economies. When the recession is turned in to a time of prosperity global competition regarding jobs will
tighten. The competitive tax systems in the East will open up for a more rapid restructuring process and better possibilities for growth and creation of jobs compared with the high tax system in the West. The major question will then once again be how we in the West are to handle the competition from low tax countries where work, savings and entrepreneurship are much more
strongly rewarded. It can today, two decades after the fall of communism in Europe, be worth addressing this long term perspective. Despite the fact that growth and development in Eastern Europe is beneficial for Western European nations, in many ways it also increases the need for tax reforms to strengthen the competitiveness of high tax Western nations.

In order to face the crisis Poland has lowered their highest tax rate from 40 to 32 percent. Bulgaria keeps the newly introduced flat tax of 10 percent and introduced new tax reductions for investors. In the Czech Republic, where the income tax is flat at 15 percent, the majority of the introduced stimulus package is constituted by tax reductions. The Baltic nations have lowered some taxes but have also been forced to raise others as the crisis has worsened. The long term commitment to low tax policies, however, seems to remain strong in the Baltics. The attitude towards taxes seems to be rather different in Eastern and Western Europe. And the high tax systems in the West can ill afford to ignore the tax competition from the east.

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