Thursday, December 15, 2011

Tax morale, eastern Europe and European enlargement

This study tries to remedy the current lack of tax compliance research analyzing tax morale in 10 Eastern European countries that joined the European Union in 2004 or 2007. By exploring tax morale differences between 1999 and 2008, it shows that tax morale has decreased in 7 out of 10 Eastern European countries. This lack of sustainability may support the incentive based conditionality hypothesis that the European Union only has a limited ability to influence tax morale over time. The author observes that events and processes at the country level are crucial to understanding tax morale. Factors such as perceived government quality and trust in the justice system and the government are positively correlated with tax morale in 2008.

More than 15 years ago, Baldwin (1995) wrote: “The gains from enlarging the EU eastward are potentially enormous. Indeed, it is easy to forget what is at stake. Until recently, millions of men and billions of dollars of equipment stood poised for combat in Europe. Communism‟s demise defused this situation by destroying the existing political and economic structures in the East. However, the outcome of this political creative destruction‟ is still uncertain. If all goes right, rapid Eastern growth would lock in democratic and pro-market reforms, fostering peace and stability throughout the continent. In particular, expanding the market to another 100 million consumers would be a bonanza for West European exporters.

However, if all goes wrong, widespread economic failure in the East could have serious consequences for all of Europe. Even if this did not provoke a return to authoritarianism, serious political or economic turmoil in the East could lead to mass migrations and harm the confidence of investors throughout Europe. An intermediate outcome is the most likely, but these two extreme scenarios serve to illustrate an important fact. Europe is at a turning point in its history.” (p. 475) In the past two decades since this statement was made, Eastern Europe has experienced substantial changes.

Eight countries from that region joined the European Union (EU) on May 2004 (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia) and two joined the EU in 2007 (Bulgaria and Romania). A democratization and marketization process (Haughton, 2007) has taken place in these countries, and such an enlargement was the most significant since the European Community was created in 1957. It was an important historical event for the EU, termed as the “big bang” enlargement (Noutcheva & Bechev, 2008), and required the building of a suitable tax system (Bernardi, Chandler & Gandullia 2005). However, it is unclear “when, why and how the EU shaped, directed and occasionally determined change in the CEE1” (Haughton 2007, p. 233).

Exploring the effect of the EU on these countries‟ policies and governance is challenging due to causality or internal validity problems: “Based on a counterfactual understanding of causality… the statement that EU causes a particular outcome implies that if the EU were to absent that particular outcome would not occur. (…) However, establishing the causal effect of the EU is far from easy even if one takes full account of alternative explanations. One problem is that factors and mechanisms we associate with European integration often generate similar empirically observable implications rather than rival implications for domestic developments. (…) Moreover, these developments might exhibit similar temporal patterns. European integration, globalisation, neo-liberal ideas, new public management, new information and communication technologies or the individualisation of society emerged in the second half of the last century and intensified in recent decades” (Haverland 2006, pp. 135, 137).
The CEE countries wanted to replicate the political system and economic success of Western Europe or the US, independent of the desire to prepare for EU membership (Haughton 2007). Our study will not be able to solve these problems as our research will be confined to the 10 EU member states mentioned beforehand who experienced the EU integration. One may attempt to disentangle potential factors through a better understanding of the EU‟s transformative power by studying, e.g., the countries and their development over time. Here we focus only on one aspect, namely citizens‟ social norms regarding compliance with tax responsibilities. In line with the literature, we refer to this as tax morale (Torgler 2007a). We will see that institutional and governance conditions are key factors in understanding tax morale. Tax administration reforms also play a key role in promoting tax morale.

However, it is interesting to check whether the EU makes a difference. Haughton (2007), for example, points out that the EU seemed to be extremely powerful, acting as a magnet in the first post-communist years, and as a gatekeeper in the path to the European Union. Noutcheva & Bechev (2008) stress: “EU‟s offer is important because it creates additional incentives to build a pluralistic democracy and pursue liberal economic reforms at home, and thus empowers political and social groups benefiting from Europeanization. On the other hand, the path of non-reform has advantages of its own for rent-seeking elites unwilling to undermine the sources of their domestic power by introducing accountability and transparency in policy making” (p. 115).

Martinez-Vazquez & McNab (2000) also argue that, in countries negotiating their accession to the European Union, the intention to accede acted as a catalyst for rapid tax reform shaped along western lines. On the road to integration with the EU, changes in the tax system were carried out to bring processes in line with developed countries (Owsiak 2007). Schimmelfenning & Sedelmeier (2004, pp. 671-676) developed different models of EU external governance. The incentive model suggests that a state adopts EU rules if the benefits of EU rewards exceed the domestic adoption costs. The effectiveness of rule transfer then increases if rules are set as conditions for rewards and the more determinate they are. The effectiveness of rule transfer increases with the size and speed of the rewards. Moreover, the likelihood of rule adoption increases with the credibility of conditional threats and promises but decreases with the number of veto players incurring net adoption costs from compliance. The social learning model on the other hand suggests that a state adopts EU rules if it is persuaded of the appropriateness of EU rules. Finally, the lesson-drawing model points out that a state adopts EU rule, if it expects these rules to solve domestic policy problems efficiently.

World Bank.Author: Torgler, Benno.Document Date:2011/12/01.Document Type:  Policy Research Working Paper.Report Number: WPS5911.Volume No:1 of 1