The tax systems in CEE/FSU countries prior to reform are summarized in terms of revenue shares in Table 1. Brief descriptions of each tax are provided in Appendix A. Note that the share of revenue in GDP was comparable to that of the social democracies of Western Europe. That said, the actual tax structures had little relationship to their counterparts in any market economy. Taxes were largely accounting devices given the prevalence of fixed prices, the need for subsidies, and quantitative restrictions. Each tax might have had a structure seemingly similar to corresponding taxes in market economies, but the difference between gross and net-of-tax prices did not serve as a signal to economic agents, and so there were few, if any, allocative incentives commonly attributed to those prices.

For example, employees were quoted net-of-tax wages, so it was not clear whether employees were aware that they were taxed. We also note the relative importance of social taxes in total tax revenues.2 These taxes were allocated to different social funds, sometimes as many as three, for retirement, health, and ­accident insurance. While the social taxes might have been shared by the ­employer and the employee by statute, such taxes were largely administratively imposed on the entities, again because employees were quoted net-of-tax wages. In effect, the combined social and personal income tax operated as a type of excise tax on labor, but again absent meaningful incentive effects commonly attributed to such charges.

Corporate, or enterprise, taxes were an important tax source in terms of recorded revenue. The tax base, however, would have been based on planned profits, turnover, or some measure of surplus. State ownership was prominent, so the distinction between enterprise profit measures and general government revenue and expenditures was largely a matter of accounting entries. This point is particularly true given the soft budget constraints under which many state enterprises operated (Kornai, 1986).

Turnover taxes were common and accounted for a significant proportion of total tax revenue. While ad valorem in nature, state-determined fixed prices limited the cascading effect of the tax. An important feature of this tax was its non-uniformity across different goods. The tax was typically determined as the difference between state-determined prices paid by purchasers and those received by suppliers. In addition, production quotas meant that tax amounts were largely determined by central authorities.

Excise taxes were more important in terms of revenue relative to market economies while covering the same basic commodities, such as alcoholic beverages, tobacco products, and motor fuels. In some cases, these charges significantly affected prices paid by consumers. For example, the increase in the tax on alcoholic beverages during the Gorbachev regime had significant revenue implications and was resisted by the population.³

It is clear from this description that political and market liberalization necessitated a change in the basic tax structure. First, tax revenues would become the major government revenue source, and second, market participants would begin to respond to the incentive effects of the taxes as prices were liberalized.

With the exception of Hungary, which began to reform its tax system in 1988, decision makers in most CEE/FSU countries had little experience with either the structure or the administration of market-oriented tax systems. In addition, the speed of transition, in particular price liberalization, privatization, and openness to international trade and investment, created a need for revenue instruments that would enable real resource transfers from the private to the public sector. Thus, it was natural for CEE/FSU countries to use technical assistance from organizations such as the IMF, World Bank, the EU (the TACIS program), the U.S. Treasury, USAID, and other organizations and individuals.

Technical assistance (TA) can provide a number of important inputs into the reform process. First, there is the transfer of knowledge about how each tax might be structured while taking private sector responses into account. Second, TA advisors can supply critical evaluations of administrative procedures, staff skill levels, training needs, and reform recommendations. Third, advisors can suggest reform phasing that helps ensure a reasonable chance of success when reforms are implemented. Phasing can be enhanced with assistance for legislative and regulatory drafting, revenue estimation, public education materials, implementation timing, and responses to private comments. Fourth, advice can be provided on how tax changes might interact with, or affect, other reform efforts. For example, advice can focus on how accounting for state enterprises might be structured and on any one-time procedures for establishing asset bases that might be subject to tax at some point after assets are privatized. Another example is advice on the structure of private sector pensions and other benefits that become part of employee compensation in private sector enterprises. Finally, access to financial resources to fund reforms was, and continues to be, an important element of TA. That is, TA consists of the donation of both human resources in the form of advisors and financial resources needed to fund particular reform elements. For example, significant funding was required for administrative reform because the computerization and training that were elements of administrative reform were particularly expensive.

TA might not be free in the sense that donors might use TA for tax reform assistance as a condition for concessional loans and grants not directly related to tax reform. This approach was used by the IMF, in particular, where concessional foreign exchange financing for budgetary and balance-of-payments support had tax-related performance requirements imposed as part of conditionality. The conditions could have been requested by the recipient governments for internal political reasons in some cases, while other conditions, revenue targets in particular, were negotiated. The imposition of such requirements generated additional TA support provided by the donor institution or others.⁴

It should be clear that the ultimate responsibility for reform was the recipient government. Technical assistance recommendations could be ignored, actively resisted, accepted, or modified by local decision makers who had to respond to multiple pressures, both internal and external.

Many government functions, laws, regulations, and practices needed to be changed in order to accommodate the transition to a market economy. It is not possible for a government with limited resources to make all the changes at once. This is because the changes are not marginal: entire departments need to be reorgani­zed, new legislation and regulations need to be drafted, procedures must be modified, public education is required, and a host of other things are necessary for successful implementation. We believe, and the history of CEE/FSU de­monstrates, that tax reform should be one of the first reforms to be undertaken.

There are several reasons why tax reforms are a prominent early reform effort. First, the government needs revenue, and the preexisting systems were inadequate for accommodating market-oriented reforms while preserving revenue. Much supposed tax revenue in the prior regimes was actually only accounting entries. This point, combined with significant state ownership, meant that instruments like profits taxes were simply allocations within government accounts because a comprehensive budget would include all revenues and expenditures with individuals and private sector entities. That is, sales between a state enterprise and the central government were transfers,⁵ but sales from the state enterprise to private agents were part of total government revenue. So, enterprise profits and taxes were allocations within a unified budget framework. The transfers were eliminated with privatization because after-tax profits are retained by private owners, while taxes are real resource transfers to the state. Thus, private owners have an incentive to minimize taxes in the context of profit maximization and respond to incentives created by the tax. The change in the nature of the relationship between government and privately owned entities, as well as the general public, forced governments to adapt by adopting tax systems that are capable of generating sufficient revenue in a market-oriented context.

Two additional points about the need for revenue should be noted. First, tax reform can be used to generate revenue needed to finance other reforms. The transition agenda is significant, but little can be achieved if the government cannot finance at least part of the transition. This was true regardless of how deeply government ultimately became involved in the economy. Market rules need to be developed, the central bank must be reformed, the state needs to provide basic legal rules and protections that ensure private property rights, and other market institutions need to be developed to provide public goods in an environment where state assets are privatized and government has a smaller, or no, role with respect to pricing.⁶ In addition, there was, and is, pressure from external donors to rationalize the revenue system. As noted, significant technical assistance resources were devoted to tax reform during the transition. This emphasis was intended to enable recipient governments to become more self-sufficient so that foreign assistance could be reduced earlier in the transition process.

Second, taxes matter because private agents have to respond by paying taxes. This means that definitions, procedures, and structures can foster the development of other transition needs. For example, accounting rules for taxation can be used to modify, or redraft, accounting laws. Definitions of concepts like entities, corporations, and partnerships can influence the development of corporate law. Also, tax rules for corporate reorganizations, liquidations, mergers, and other technical issues generate the demand for reasonable corporate and business laws.

Finally, rationalization of tax structures, accommodated by administrative reform, can be seen as an important element in addressing corruption. All CEE/FSU countries had elements of corruption in the tax administration. While a common­ claim, it was never clear whether the tax administration was more corrupt than other parts of the government where bribery for licensing, for obtaining contracts, and for misappropriating government expenditures were apparent. That said, addressing corruption in the tax administration enabled revenues to increase because of reduced leakage via bribes, at a minimum. These increases could finance more transparent public expenditure delivery, reducing the demand for alternative enforcement mechanisms. For example, the Russian government, among others, was not able to enforce private property rights and contracts during the early transition, and organized crime provided such protective services for those who had the means to pay. In effect, the government was competing with the private market, mostly illegal, to provide some local public goods and services (see Alexeev et al., 2004b). Those protected in this manner had no incentive to pay taxes for services they did not receive from government. Over time, government revenues became sufficient to address some aspects of corruption and to begin to provide services that substituted for the illegal market services. Corruption will never be eliminated, but a reasonable revenue collection system that is depersonalized in the sense that there is reduced personal contact between tax administrators and taxpayers provides a sound means to rationalize both taxes and expenditures.

Despite some important commonalities, each economy in the CEE/FSU is unique. That said, three factors affected the speed of adjustment to the initial transformation. These factors are presented in Table 2, where some indicators capture the speed of adjustment necessary to stabilize the economies. First, the proportion of assets held privately is positively related to the speed of adjustment. Adjustment speeds were two to three years for countries with more than 10% of the assets held privately in 1988, with the exception of Romania. Note that Albania, Russia, and Ukraine all had private asset shares of less than 5% in 1988, and it took more than five years for those economies to stabilize, according to our definition. The second factor is the proximity to the EU border. Those countries, except Ukraine, which bordered the EU took less time to stabilize. Note also that the date of EU accession is positively related to the stabilization periods. This could be because those countries bordering the EU were eager to join the EU and NATO, so they adopted reform policies consistent with market stabilization more rapidly. In addition, those in proximity to the EU were more familiar with market-oriented policies. A third factor could have been the break-up of the Soviet Union.⁷ FSU countries had to deal with both an economic transition and the transition to the status of independence, which required the development of government institutions, a new currency, a central bank, and new international relationships. By the same token, Russia had to adjust to a smaller economy where prior investments had been made without regard to what became national borders, particularly for vertically integrated state enterprises such as mining and refining.⁸

The VAT is an accrual-based tax12 while many taxation elements under the prior regimes were cash based. The major reason for an accrual basis is administrative simplicity. Under accrual accounting, invoices are required only to track taxable events, whereas cash accounting requires two sets of receipts: first, a record of the supply of taxable goods and services and second, a record of payment. The supply and the payment then need to be matched in order for the tax administration to be able to confirm the entire transaction.13 The inconsistent timing of the supply of goods and services and the payment has two effects. First, the compliance cost to taxpayers and tax administrators is increased because of the need to match payment with actual supply. Second, the difference in timing, combined with the ability to manipulate the type of payment, raises additional evasion opportunities.

Evasion opportunities are illustrated by the Russian VAT during the early reform period. At that time, the Russian VAT was on a cash basis. In addition, the Russian VAT contained the normal exemption for financial transactions such as loans, interest, and loan repayments. This combination created an incentive for the purchaser of goods or services covered by VAT to give a loan to the seller in order to avoid the VAT. For example, suppose Taxpayer A supplied goods to Taxpayer B with a value of 1,000 and the VAT for the transaction is not payable until the time Taxpayer B pays Taxpayer A. Suppose further that the VAT rate is 15%. This means that the tax-inclusive price would be 1,150 (1,000 + 0.15 × 1,000). Taxpayer A records an account receivable of 1,000, and Taxpayer B records an account payable of 1,000. Suppose, however, that Taxpayer B makes a “loan” to Taxpayer A of 1,000 at some stipulated interest rate. No VAT is paid on the loan because it is exempt, and no VAT is accrued on the supply of goods because Taxpayer B has not “paid” for the goods. Suppose now that Taxpayer A defaults on the loan and Taxpayer B defaults on the payment for the supply. The account receivable and the debt are canceled, leaving Taxpayer A with an additional 1,000 on the books.14 Likewise, the loan and the account payable are canceled, leaving Taxpayer B with a reduction in cash of 1,000. At the same time, there would be no VAT liability.

Various forms of this scheme were used in Russia while the VAT was on a cash basis. The Russian response was to impose a VAT on loans, again on a cash basis. In this case, the VAT would have been paid at the time Taxpayer B made the loan to Taxpayer A, and Taxpayer A would have gotten a credit for the VAT of 150. If the loan were paid back, then Taxpayer A would pay Taxpayer B 1,150 (in present value terms perhaps). Taxpayer A would get a credit for 150 and Taxpayer B would pay 150, netting to zero. If, however, Taxpayer A defaulted, then Taxpayer A should have received a credit for 150 and Taxpayer B should have lost the credit of 150. Again, the net VAT value of the transaction is zero. Finally, if Taxpayer B defaulted on the payment to Taxpayer A, then the state would still have lost 150 because no cash had been transferred to match the supply of goods.

The Russian law should have prohibited transactions where loans were used to effectively pay for taxable supplies if cash accounting was the basis for the VAT. This is because financial transactions should be exempt (such transactions are not consumption), and making them subject to VAT inhibits the development of the capital market where many loans are legitimate. The administration of such prohibited transactions would be difficult, however. The tax administration would have to identify both supplies of goods and supplies of loans, making tracing more difficult. The correct answer was to move the VAT to an accrual basis, which the Russian government did when it introduced Part II of the Tax Code in 2001 (although small taxpayers could still pay VAT on a cash basis).

Exemptions for goods and services under the VAT should be limited to financial transactions such as loans, interest, purchases of equities (savings in general), dividends, and trade in gold with the central bank.¹⁵ Exempt taxpayers should be limited to nonprofit entities and small taxpayers based on a turnover threshold. In contrast, proposed exemptions in CEE/FSU countries were common during the transition period. The exemptions were justified either on distributional grounds or on the basis of targeted industries. For example, food was often exempted, or proposed for exemption, on distributional grounds. This created revenue difficulties in some countries such as Bulgaria. In 1992, the Bulgarian government proposed to exempt food until a revenue estimate based on consumer expenditure surveys showed that such an exemption would reduce VAT revenue by nearly 50%. In addition, food going into the restaurant sector was exempt, but the restaurants charged VAT on the service, including food, which made the exemption­ ineffective for such services, at least in theory. In addition, exempting food (or using a lower VAT rate for foodstuffs) is often counterproductive even on distributional grounds because, at least in some countries, poorer households often buy food at farmers’ markets or other small establishments, which are exempt because of their size, while richer households shop in large supermarkets, benefiting from the foodstuffs exemption.

Other exceptions were for the output of specific industries such as electricity. In the case of electricity, the argument was that electricity prices were controlled, resulting in significant losses for state electricity producers and creating a situation where the producers could not, or would not, pay the VAT to the government. The flaw in this reasoning was that the VAT would be paid by consumers of electricity, not by the electricity producers. The recommended answer to the accounting difficulty had the producers charge VAT and then enter a VAT payable in the government accounts. That way there could be a clear separation between the VAT and the enterprise’s operating loss. Over the longer term, the issue was resolved by restructuring state enterprises and introducing more rational pricing.

Two sectors that are particularly difficult to tax under a VAT are agriculture and nonprofit entities such as educational institutions, religious organizations, and organizations that provide goods and services on a nonprofit basis, such as thrift shops and medical facilities. The problems arise because if such producers­ are exempted, then a credit for inputs is not available to them. Alternatively, requiring VAT registration would entail refunds for input credits. Another option is to exempt inputs from VAT, but this scheme requires the same registration and accounting as does full registration with refunds for input credits. As shown in Table 3, countries used different treatments during the early reform period. For example, Estonia, Latvia, and Lithuania simply adopted the EU treatment of both sectors, using reduced rates for agriculture and exempting NGOs that did not produce taxable goods and services. The same treatment was adopted by other countries seeking rapid accession to the EU, such as Poland, the Czech Republic, Slovakia, and Hungary. Russia, Ukraine, and Albania appear to have been the outliers, with collective farms being exempt in Russia and Ukraine and with thresholds for small agricultural producers in Albania. Nonprofit entities were VAT-exempt in Russia and Albania but were subject to different rules in Ukraine depending on status.

Obtaining credits, particularly refunds for excess credits, is a consistent problem in all emerging economies (see Conrad and Alexeev, 2024) and was an important issue in countries like Russia, Ukraine, and Bulgaria. Export refunds were particularly problematic, but refunds were also an issue for domestic transactions. For example, suppose that during the initial investment period a VAT taxpayer makes large capital expenditures subject to VAT but has little or no taxable output, generating­ excess credits. Unless the taxpayer receives a refund, the taxpayer’s working capital is significantly reduced. In effect, the taxpayer is making an interest-free loan to the government until the project starts producing and selling output; excess credits could offset the taxpayer’s VAT liability. Some VAT taxpayers could also have excess credits at various points throughout the year. For example, a VAT taxpayer could import large amounts of consumer goods that would be sold throughout the year. Finally, there is VAT-specific fraud such as fly-by-night firms and false invoicing, where VAT taxpayers can create excess credits artificially. These schemes are equivalent to theft because credits are equivalent to cash.¹⁶

The credit for input VAT should be immediate on an accrual basis because the economic intent of a destination-based VAT is to impose a tax on the consumption of domestic residents at the time when goods and services are transferred to those domestic residents. Some governments, however, did not pay refunds, particularly export refunds, on a timely basis or not at all during the transition. There were at least two reasons for this inefficient response. First, governments claimed that the presence of excess credits in the domestic context was an indicator of fraud. For example, the Russian government claimed that fly-by-night firms were being created in the country. Suppose Taxpayer A sells taxable goods to Taxpayer B for 1,000 and the VAT is 15%. The VAT would be 150, with Taxpayer A paying the net VAT to the government and Taxpayer B getting the credit for 150. Suppose, however, that the two taxpayers organize a “fly-by-night” firm that is a taxpayer named Taxpayer C. Now Taxpayer A can sell to Taxpayer C for a low price, say 400, and pay 60 to the government (assuming no input credits). Then Taxpayer C can sell to Taxpayer B for a “regular” price of 1,000 and collect 150 in VAT from Taxpayer B. Now Taxpayer C has cash of 90 (150 received from Taxpayer B less 60 of VAT paid to Taxpayer A), which is supposed to be paid to the government. If, instead, Taxpayer C disappears, then the government has lost 90, which can be shared between Taxpayers A and B. It is true that such schemes were introduced in the region as the VAT was implemented. Note, however, that the scheme is not the fault of tax design but of the registration system. Taxpayer C has to be a VAT taxpayer in order for the scheme to work, so the initial fault lies with registration procedures. In addition, note that the absence of excess credits by Taxpayer B (or Taxpayer A for that matter) is not a sufficient condition for the presence of a fly‑by-night firm. A legitimate VAT taxpayer could have an excess credit position. These points combined show that failing to pay refunds is not the most effective way to attack this type of fraud.

Lack of understanding was a second source of the delayed refund problem. Government officials and the public did not understand that zero-rating exports, and the need for export refunds, are a necessary element in a destination-based VAT. In addition, there were claims, particularly in Russia and Ukraine, that VAT taxpayers­ would export goods, claim the refund, and then smuggle the goods back into the country and sell the goods on informal markets, keeping the refund. Note again that this problem is not an inherent issue with VAT’s design. Rather, it is an issue of border control. VAT taxpayers could also smuggle imported goods without having to export them first and sell them on informal markets. In both cases, the revenue loss is identical if the values of the goods sold on the informal markets by the domestic producer and importer are the same. That is, the problem, again, is border control.

Another source of misunderstanding is the fact that the VAT paid on inputs is not government revenue. Input VAT will be credited on sales to domestic residents (and perhaps refunded in part) or refunded in total in the case of exports. The lack of understanding is illustrated by treating VAT refunds as a government expenditure in Ukraine. In effect, the Rada had to approve the total amount of refunds as part of the budget process. The government’s VAT revenue is only the revenue accrued from the final sale to domestic residents, although the advantage of the VAT is that revenue is collected in pieces throughout the chain of value added. One way to deal with this revenue recognition issue is to effectively sterilize some amount of VAT revenue on an accrual basis. Such funds could be used to finance refunds so that only net VAT is entered into the government revenue account. Such a method could be used until such time as revenue accounting becomes normalized.

The refund problem has been addressed in a number of ways both in CEE/FSU and more broadly. For example, large imports of goods and services during­ a startup period of an investment project have been exempted. There is also the option­ for VAT taxpayers to hold excess credits and apply that excess to future VAT accrued, with perhaps a type of annual reconciliation, although this would mean that taxpayers are making an interest-free loan to the government. In addition, some taxpayers deemed honest can be made eligible to receive rapid refunds, such as under the approach used with grain exporters in Ukraine. All these methods­ were tried in some form during the transition. In addition, Bulgaria develop­ed a new (inefficient) method, which was considered in Russia and adopted­ in part in Ukraine. This method might be called “VAT accounts” and worked in the following manner.¹⁷ Each taxpayer was required to establish a VAT bank account. The taxpayer purchasing inputs would deposit the VAT on those purchases into the VAT account of the supplier18 instead of paying the supplier directly. VAT on sales to persons who were not taxpayers was deposited into the taxpayer’s VAT account. At the end of the month, the seller would report the value of VAT on sales deposited into the seller’s account and claim credit for the VAT paid into the accounts of other taxpayers, or on imports as the case may be. The positive difference would be collected by the government, and the negative difference would be carried forward by the taxpayer. Note that this procedure converted the VAT from an accrual basis to a cash basis, at least for credits. The government felt it was assured that VAT had been paid on all transactions before credits were allowed and export refunds were granted. The cost of this conversion, however, was to require taxpayers to match the receipts and payments and to maintain additional accounts. Furthermore, information requirements increased because each deposit into the supplier’s account required another statement showing amounts as well as the taxpayer identification numbers of both the buyer and seller. After review, Russia rejected the proposal. Bulgaria kept the scheme until the country joined the EU, at which time the system had to be compatible with EU standards. Ukraine still maintains a system similar to the Bulgarian system.

The experience of VAT adoption in this region is similar to the experience of other emerging economies. Implementation was uneven but stabilized over time. See Table 4 for the current, stabilized VAT structures in the region. In addition, there was much learning by doing, country-specific experiments, and a lag between legal adoption and reasonable administrative reform.

As noted, individual income taxation was part of all prior regimes but was essentially limited to wage withholding and could be perceived as an excise tax on labor at the time of liberalization (see Table 1 for shares in total tax revenue). Individual taxpayers soon learned that wage withholding was a prepayment for their individual tax liabilities. In addition, wage withholding was paid to local tax offices before liberalization in countries such as Russia and other countries that emerged from the Soviet Union, so there was little notion of a comprehensive personal income tax administration at the national level. Reforms needed to address several issues in order for a modern income tax to emerge. First, there was an issue about whether to adopt some notion of comprehensive personal income taxation. Initially, income elements were subject to a schedular system. For example, wage withholding was a final tax at a particular set of rates while items like interest income could be exempt, which created arbitrage opportunities. In addition, entities and employees had an incentive to arbitrage definitions. For example, “wages” were subject to withholding, but loans, perhaps at zero interest, could be supplied to employees, management in particular, as a substitute for wages. The loans could then be written off as bad debts, so the entity and the employee could arbitrage the tax until form‑over-substance rules could be developed by the tax administration.

Comprehensive income usually implies annual reconciliations by each taxpayer, where income is aggregated into a unified value for determining the tax base. Such individual filing was, and is to some extent, beyond the capacity of the tax administrations in most CEE/FSU countries. It is possible, however, to approximate aggregate individual income via the use of advance payments withheld by the payer (see Conrad and Alexeev, 2024). In effect, schedular taxes withheld could be transformed into a proxy for comprehensive taxation. A flat-rate tax on wages and benefits plus withholding on all other income payments at the same rate facilitates this approximation. Filing would still be needed for some individuals, such as those operating small businesses and individuals entitled to refunds. The governments, however, have been hesitant to provide refunds and to expand individual filing, and prefer to use small business taxes as an alternative comprehensive income measure. Thus, a schedular system has evolved in most countries where wages might be subject to progressive rates with flat-rate withholding on some, but not all, other income accruing to individuals. These facts are illustrated in Table 5. Sole proprietorships are generally subject to small business taxes, or presumptive income taxes, while wage withholding can be a final payment and there is withholding on interest and dividend income in most countries. Note, however, that some countries such as Bulgaria, Estonia, Hungary, Romania, Russia, and Ukraine eventually opted for flat-rate taxation on wages. Progressivity is added to the system via the use of personal exemptions, as noted in Table 5.

Note that the personal income tax rates are generally lower than those in other countries. This is so, in part, presumably because of the significant social taxes that are still imposed to fund retirement and other social benefits. Combined employee/employer social tax rates exceed 30% in most cases. The presence of the combined personal income tax and social tax rates created a significant incentive for individuals subject to high rates to arbitrage the system by choosing, with the agreement of firms, to be “contractors” or “small businesses” instead of “employees.” This incentive was particularly strong in Ukraine and Russia where many individuals, in particular professionals such as computer programmers, became independent contractors. The countries responded by clarifying the definition of “employee” to reduce the number of individuals who could arbitrage the system. This approach has never been satisfactory, and some advisers, including us (see Conrad and Alexeev, 2024), recommended that a withholding tax be imposed on the services of individuals who are not otherwise employees.

Entity taxes were an important revenue source under the prior regimes. The tax bases, however, differed from common market-oriented corporate taxes. For example, there was a type of addition-based VAT in Russia where the tax base was some measure of profits plus wages.¹⁹ Other countries used turnover or planned profit. The tax base may have been largely irrelevant for enterprise decision-making given fixed prices, state ownership, and exogenously imposed production quotas. The situation changed rapidly with privatization, the development of domestic private investment, and competition for foreign investment. In addition, governments wanting to join the EU needed to rapidly develop tax regimes that were compatible with those in Western Europe. Finally, the link between corporate and individual taxation and the potential for some form of corporate integration had to be examined and understood.

Entity tax reform did not occur in a vacuum with respect to overall legal reform. There had to be reforms to corporate law where issues of the definition of a legal person, bankruptcy, mergers, acquisitions, and intercorporate relationships such as subsidiaries, liquidations, and shareholder protections needed to be developed or refined. In addition, accounting laws needed to be either developed or modified in order to be consistent with international standards. As noted in the introduction, tax reform helped create an impetus for such reforms because of the importance of income definitions in determining the tax base.

The speed of liberalization forced some governments to catch up in order to preserve revenue. The speed of reform, combined with lack of experience, created a number of problems. For example, there were many issues with the definition of the tax base, which became based on accrual accounting. Problematic definitions included the following:

• 1. Depreciation;
• 2. Accounts held on an accrual basis;
• 3. Interest expenses;
• 4. Loss carryforwards (a particularly thorny issue given that governments believed that corporations were reporting artificial losses that could be carried forward);
• 5. Transfer pricing (both domestic and across borders) given the expansion of foreign investment both by foreign firms and by domestic firms abroad;
• 6. Treatment of natural resources;
• 7. Treatment of interest on debt and thin capitalization rules; and
• 8. Bad debts and other industry-specific provisions such as research and develop­ment.

Some countries, Estonia for instance, adopted international accounting rules with adjustments, while other countries such as Russia included income definitions in the tax laws.

Tension existed between a reasonable definition of the tax base and the desire to increase domestic investment. Some of the countries attempted to attract investments via the use of incentives such as investment tax credits in Ukraine, and tax holidays in Russia (in the regions), Ukraine, Kazakhstan, Albania, and Bulgaria.²⁰ Export incentives were common, including in Bulgaria, the Czech Republic, Poland (from export processing zones), and Romania, among others.21

It took some time for the systems to stabilize, but now most countries have corporate taxes consistent with common practice. This result is illustrated in Table 6. There are exceptions. For example, Estonia has a system where only distributions are taxed. That is, no taxation is imposed on corporate retentions. This method was claimed to create an incentive for reinvestment. The method, however, is a variant of the corporate tax where distributions plus the gain in market value of the equity are taxed (see Conrad and Alexeev, 2024). The absence of a tax on the accrued gain (or loss) creates a number of adverse incentives. First, there is an accounting issue about the definition of taxable distributions. For example, shareholders could make loans to the corporation and avoid the dividend tax via the use of interest deductions. Such incentives created the need for significant definitional modification through time. In addition, there is a lock-in effect where there is an incentive to retain earnings and make investments that yield a return lower than the tax-inclusive market return, thereby lowering real income.22 There is also a perverse effect where there is an incentive to make distributions during times of reduced economic activity and to retain earnings during growth periods. This ­effect reduces the automatic stabilization features of taxes during the business cycle.

Note that most countries use a variety of depreciation methods, loss carryforwards, and other potentially problematic aspects of corporate income taxation listed above. The range, however, is within the variation found in practice throughout the world. A final point is how the link between individual and corporate taxation is addressed. Some countries have a classical system where dividends are taxed, perhaps via withholding as a final tax, and capital gains are taxed, usually on a nominal basis. Other countries, however, have adopted a type of partial corporate integration where corporate dividends are exempt from personal taxation, as in Lithuania, or taxed at a lower rate, as in Slovakia.

Excise taxes were often used prior to the reform period, in Russia in particular. The main issues related to excises during the reform period have to do with scope and rates. All countries were advised to limit excises to the three types of commodities that are large revenue sources: alcoholic beverages, tobacco products, and petroleum products. As shown in Table 7, the countries generally adopted this approach with some variation with respect to other excisable goods, automobiles in particular. Countries examined three issues in making excise tax reforms.

First, there was the issue of what exactly to tax. Under a negative externality approach, the tax should be imposed on the ingredient responsible for the externality, e.g., alcohol content in the case of alcoholic beverages. The countries did not adopt this approach in general but chose to tax the final output, perhaps at different rates, such as beer compared to spirits.

A second issue was cascading. Excises are best administered by imposing the tax at the factory gate, except perhaps for motor fuels, because of the admini­strative advantage of controlling fewer taxpayers producing effectively in bond. Cascading can arise in such cases. For example, some alcoholic beverages are used as inputs into other beverages, such as brandy. Cascading can be addressed by allowing a credit for the excise tax on the input, as in Russia and Georgia. Other countries followed the EU method of suspending excises in cases where there is a clear chain of value added in bond. Most countries, except Ukraine, impose the tax at the factory gate, but some approximate an ad valorem retail tax by imposing an ad valorem tax on the manufacturer’s suggested retail price.

Third, rates may be constrained because of smuggling concerns. This is true in the EU, where EU directives allow only minor variation in rates. Countries outside the EU have the same problem to the extent that smuggling can be prevalent.

Tariffs were not an important element of the revenue system in the region’s countries prior to reform. The state controlled international trade and access to foreign exchange, so tariffs had little economic meaning. Protection and revenue motives provided an incentive for countries to adopt tariffs during the reform ­period. Average tariff rates for agricultural products and non-agricultural products­ in 2024 are shown in Table 8. Countries that joined the EU share a common tariff policy for the union. Other countries are free to choose their own rates. Note that most countries attempt to protect agriculture and that almost all countries are in line with EU policy. The same point can be made regarding non-agricultural tariffs, except that most countries outside the EU impose rates that are slightly higher than EU rates. That said, non-agricultural tariffs are not excessive.