Download Failure of the Washington Consensus on Inequality and the

1
Forthcoming in Challenge magazine
FAILURE OF THE WASHINGTON CONSENSUS ON INEQUALITY AND
THE UNDERGROUND ECONOMY IN THE TRANSITION ECONOMIES
J. Barkley Rosser, Jr.
Professor of Economics
MSC 0204
James Madison University
Harrisonburg, VA 22807
Tel: 540-568-3212
Fax: 540-568-3010
Email: [email protected]
Marina Vcherashnaya Rosser
Associate Professor of Economics
MSC 0204
James Madison University
Harrisonburg, VA 22807
Tel: 540-568-3094
Fax: 540-568-3010
Email: [email protected]
August 2000
We wish to acknowledge useful inputs from Ehsan Ahmed, John Bonin,
Simon Commander, Branko Milanovic, and the late Lynn Turgeon. None of
these are responsible for any errors, omissions, or misinterpretations in this
paper.
2
New Russian in Mercedes Store: "I would like to see your most expensive car."
Mercedes Store Manager: "Didn't you just buy one in here yesterday?"
New Russian: "Yes, but the ashtray is full already."
It is well known that income distribution in many of the transition economies
has become sharply more unequal during the transition process since the end of
the 1980s.1 By and large the attitude of most policymakers in Washington and in
many international institutions has been that although this phenomenon has been
somewhat unfortunate, it is a necessary outcome to be expected and, within
bounds, to be desired. The centrally planned economies were viewed as having
too much equality, as not offering sufficient incentives for growth opportunities. It
has been considered that it was inevitable that in moving to market capitalism
there would be increases in inequality as these incentives became available.
The main concern has been that if this increase became too great, this would
lead to a political backlash that would halt or reverse the transition process and
bring back the former system. That some transition economies such as Russia
now have more unequal distributions of income than even the United States 2 is
viewed more as an annoyance than as a problem that must be resolved.
On the other hand, the especially rapid growth of the underground economy in
the transition economies is viewed somewhat more seriously,3 although as
perhaps a more extreme case of a more general global problem.4 This is seen
as undermining state finances as those participating in the underground
economy avoid paying taxes, nonreporting of income being perhaps the most
widely agreed upon way of identifying what constitutes underground economy
3
activity. The budget deficit problems that can arise if large proportions of
economic activity are not reported and do not result in tax payments can become
a problem, at least in the eyes of the international lending institutions that may
have demanded conditionality agreements with the nations in question requiring
reduced budget deficits before lending them money. It is also understood that
the crime and corruption that often accompanies such underground activities can
corrode the political legitimacy of the system, and may even spill over into the
high income non-transition economies as they become havens for money
laundering and other related scams and scandals, some of which may even
potentially affect the solvency of western financial institutions.
What has only dimly begun to be recognized is that there may be a link
between these two problems. It is clear that a decline in the fiscal health of a
transition economy may lead it to cutbacks in social safety net spending,
especially when such cutbacks are being demanded by international lending
institutions as part of getting its budgetary house in order. What has been less
clearly understood is that this may well be a two-way street relationship, with
causation possibly working in the opposite direction as well. Increasing income
inequality itself may well contribute to the growth of the underground economy in
the transition economies.
Now, the role of the underground economy in the transition economies is a
matter of considerable controversy. Although widespread publicity connects it
with outright criminal activity and associated money laundering in western banks,
it may well perform a socially beneficial function in economies that are overly
4
regulated or in which there is bribery and corruption by rent-seeking bureaucrats
who may well be officially enforcing the overly strict regulations.5 In such
situations the only way that entrepreneurs can form what would be viewed as
legitimate enterprises is to hide them from the "grabbing hand" of the corrupt
authorities.6 Efforts to bring the underground economy above ground would lead
to "throwing out the baby with the bathwater."7 The hope of this view is that the
current underground economy participants will provide a foundation for a future
functioning above ground economy, much as the notorious "Robber Barons" of
the nineteenth century in the U.S. became the fathers of respected corporations
and philanthropic institutions. Even if they do not do so, their activities may
stimulate the above ground economy through multiplier effects.8
Although it is recognized that in some of the transition economies there may
still be such levels of excessive regulation and associated bureaucratic
corruption, Russia and Ukraine standing out as such examples, nevertheless the
apparently rapid growth of the underground sector has come to be viewed with
concern by most policymakers both within the countries in question and
internationally, if only because of the fiscal implications. Some have suggested
that countries may face two very distinct alternatives: a "good equilibrium" of not
much underground economy and a functioning and honest public sector versus a
"bad equilibrium" of a large underground economy and a poorly functioning
public sector unsupported by tax revenues. Some have suggested that this
relates to ideas regarding the behavior of mafias and social capital, where there
are increasing returns to people obeying the law and being involved in socially
5
worthwhile activities. However, if such behaviors fall below certain critical levels
then the opposite phenomenon can emerge, a breakdown of law enforcement
and the emergence of socially damaging behaviors.9
This suggests that if the underground economy reaches some critical
threshold level it can simply overwhelm the above ground economy and come to
dominate it. Such an argument fits in well with the idea of sharply diverging
possible outcomes with regard to the underground economy. Furthermore, it
becomes clear in the context of transition economies that it may be possible for
the enormous changes that these economies have experienced to push them
over such thresholds and towards patterns in which there are very large amounts
of underground economic activity that remain underground and become a selfreinforcing phenomenon.
What are the factors that might push an economy towards moving beyond
such a critical threshold? The original literature on underground economies
dates from the late 1970s and early 1980s and focused upon their emergence in
advanced market capitalist economies. This early literature argued that higher
taxes and higher social transfers would lead to larger underground economies as
people would face incentives to avoid taxes and to be out of work so as to
receive social transfers.10 The implication of such arguments is that if high taxes
and large social transfer payment programs are associated with greater income
equality, then one should expect to see income equality associated with a larger
underground economy. Never in this traditional literature was it ever suggested
6
that the relationship might possibly run in the opposite direction, that an increase
in inequality might lead to increases in the size of the underground economy.
That such a possibility might occur in the case of the transition economies has
now been suggested, with a finding that there is a strong correlation between the
size of the underground economy and the degree of income inequality as
measured by the Gini coefficient in 1994.11 Of course, these economies have
experienced profoundly unusual and disruptive circumstances, with large-scale
institutional transformations and upheavals occurring of many sorts. Many of
them experienced massive declines in output and hyperinflationary outbreaks, as
well as wars, political instabilities, and a variety of other extreme events. That
such events could lead to breakdowns of social solidarity and increases in
alienation and general disillusionment is not in the least surprising.
Some of these elements appear also to be connected to the rise of the
underground economy.12 However, the only one that appears to be more
strongly connected to the size of the underground economy than the size of the
Gini coefficient, at least as of 1994, is the cumulative decline in output from 1989
to 1994, with the maximum rate of inflation also playing a role, but not as great as
the Gini coefficient. Other variables that might be expected to play a role either
do so much less strongly or not even with the expected effect. Thus, democratic
rights appear to be insignificantly negatively correlated with the size of the
underground economy, while economic freedom has a negative bivariate
correlation but a significant positive correlation with the size of the underground
economy in a full multiple regression. Although maximum tax rates on capital
7
appear to be significantly positively correlated, maximum tax rates on labor
actually appear to be negatively correlated with the size of the underground
economy, in contrast with most of the existing literature.13
These findings coincide with a broader reevaluation of transition policy that
has been taking place. Thus, whereas at one point most international officials
advocated "shock therapy" approaches in which all problems of transition ranging
from macroeconomic stabilization through institutional restructuring to
privatization were to be all attacked simultaneously and with equal vigor, it is now
clear that for some of these, especially privatization, a more gradual and careful
approach may well be called for, with the relatively successful case of Poland
who stabilized the macroeconomy quickly, but has been slow to carry out
privatization being an important example. The issue of the speed of privatization
has been especially noted as being linked with the rise of the underground
economy and corruption as many economies, such as Russia's, that
implemented rapid privatizations discovered that these policies resulted in insider
takeovers, corrupt asset stripping, and other dysfunctional outcomes. 14
Table 1 below presents a summary of data relevant for this discussion. We
note that there are very serious problems in measuring the relative sizes of
underground economies in any economy, much less in a transition economy in
which previously stable relationships are breaking down or otherwise changing.
Thus, it may be that the most widely accepted estimates of the size of the
underground economy in advanced market capitalist economies rely upon
estimates of the use of currency compared to GDP.15 But for transition
8
economies such estimates are not very meaningful given the enormous
restructurings the financial sectors of these economies have experienced.
Rather, examining patterns of electricity usage have been the most commonly
used for the transition economies, although any method has its limitations in any
economy, and it must be recognized that such measures ultimately involve
attempting to measure the unmeasurable.
Table 1 presents data for 18 countries on the size of the underground
economy in 1994 (UE) as a percent of GDP and the change from 1989 to 1994 in
the size of the underground economy (dUE), the Gini coefficient in 1994 (GC)
and its change from 1989 to 1994 (dGC), the cumulative percentage decline in
output from 1989 to 1994 (CD), the maximum annual rate of inflation after 1989
(IR), a economic freedom index in 1994 (EF), a democratic rights index in 1994
(DR), both 0-100 with a higher number indicating more economic freedom or
democratic rights, and the effective marginal tax rates on labor income (LT) and
capital income (CT), respectively.16
9
TABLE 1
SUMMARY DATA ON TRANSITION ECONOMIES
Country
UE
Belarus
15.0
Bulgaria
29.4
dUE
GC
dGC
EF
DR
LT
CT
-0.4 .248
.014 39.3 1994.0 37
50
71
99.2
6.7 .340
.110 27.4
338.8 73
83
57
93.5
Czech Republic 17.2 11.2 .239
.035 21.4
52.1 90
92
69
85.2
946.7 90
75
49
74.9
.270 74.9 8273.5 37
33
n.a. n.a.
.02
24.6
Georgia
62.2
37.7 .560
Hungary
28.1
1.1 .243
34.6 87
92
73
81.0
Kazakhstan
30.6
13.6 .328 .053 51.2 2566.6 40
25
62
98.6
Kygyzstan
39.2
16.3 .553 .293
50.6 1365.6 77
58
58
96.7
Latvia
32.6
19.8 .270 .018
52.0
958.2 80
75
55 80.0
Lithuania
30.2
18.9 .348 .100
61.1 1162.6 83
83
53 94.3
Moldova
36.8
18.7 .360 .111
60.6 2198.4 57
50
37 97.2
Poland
15.8
0.1 .310 .045
17.8
639.6 87
83
62
84.0
Romania
16.9
-5.4
26.4
295.5 73
58
57
94.2
Russia
38.5
23.8 .446 .186
48.3 2510.4 67
58
55
97.8
Slovakia
15.4
9.4 .200
25.1
58.3 87
15
68
87.6
Slovenia
25.0
-1.7 .251 .036
16.8
246.7 83
92
63
92.6
Ukraine
41.8
25.5 .330 .098
52.1 10155.0 27
58
63
99.3
9.8
-1.6 .330 .038
15.6
25
45
97.8
.278 .048
0.0
34.9
IR
Estonia
Uzbekistan
5.7 .392 .127
CD
18.3
1232.8 43
10
Much of what one sees from this table fits the conventional wisdom of the
Washington Consensus. Thus, we find the more reformed and democratic
countries in Central Europe, such as Poland, Hungary, the Czech Republic,
Slovakia, and Slovenia, with somewhat smaller underground economies and
greater macroeconomic stability. They also generally have more income equality
and also tend to have higher tax rates on labor income but not on capital income.
Russia, Ukraine, Moldova, and Georgia all have larger underground economies
and considerable macroeconomic instability. They all generally have higher
income inequality and higher capital income tax rates (Georgia unknown).
But then, there are a number of apparent anomalies. The Baltic countries are
somewhat mixed in their patterns, not even resembling each other particularly on
some of these variables. The Central Asian countries are a mixed bag, with
Uzbekistan showing a pattern that makes it look more like one of the Central
European countries, at least on the economic variables.17 And, notoriously
undemocratic and unreformed Belarus shows up with both a relatively small
underground economy and a relatively equal distribution of income.
Furthermore, there is good reason to believe that the income distribution
policies, especially in the form of social transfers, vary greatly among these
countries. Thus, the very low reported Gini coefficients in Slovakia and the
Czech Republic may not be accidents or mere artifacts of high tax collections
due to small underground economies. Studies suggest that their transfer policies
have been much more effectively targeted towards the poor and those impacted
negatively by the transition, such as generous unemployment benefits and family
11
assistance.18 The programs in somewhat less equal Poland and Hungary are
reported to target the middle class, especially their generous pensions, whereas
the transfer programs in Russia are reportedly regressive in effect, making even
more unequal a distribution of income that has become sharply unequal during
the transition.19
All of this suggests that the original Washington Consensus may have been
mistaken to ignore income distribution policies, or even to applaud increases in
inequality, as appears to have been the case. It is clear that there are now quite
a few people in some of the institutions that developed that consensus who have
been documenting the large increases in income inequality that have occurred in
many of the transition economies, even as their superiors seem so far to have
largely ignored these findings. Likewise, they have documented that the nature
of social safety net policies have in fact influenced the outcomes regarding
income distribution. We also now see that income inequality itself may well play
a role in increasing the size of the underground economy through social
alienation and general dislocation, especially in conjunction with macroeconomic
instability. Given that a large underground economy makes it hard to raise tax
revenues to pay for a social safety net, there is a potential negative feedback
effect that it would be wise to avoid. Thus, there would appear to be a case for a
serious reconsideration of policies with regard to income distribution in the
transition economies in light of this apparent interaction with the underground
economy. Not only political legitimacy, but economic stability may call for more
vigorous efforts to maintain income equality in the transition economies.
12
NOTES
1. For example, see Frances Stewart and Albert Berry, "Globalization,
Liberalization, and Inequality: The Real Causes," Challenge (JanuaryFebruary, 2000): 44-92, Branko Milanovic, Income, Inequality, and Poverty in
the Transition from Planned to Market Economies (Washington, World Bank,
1998), and Simon Commander, "The Impact of Transition on Inequality,"
Economics of Transition (5, 1997): 499-504.
2. See Timothy Smeeding, "America's Income Inequality: Where Do We Stand?"
Challenge (September-October, 1996): 45-53.
3. See Simon Johnson, Daniel Kaufmann, and Andrei Shleifer, "The Unofficial
Economy in Transition," Brookings Papers on Economic Activity (2,
1997): 159-221. Other terms for this sector include "unofficial, informal,
shadow, irregular, subterranean, black, hidden, and occult."
4. See Friedrich Schneider and Dominik H. Enste, "Shadow Economies: Size,
Causes, and Consequences," Journal of Economic Literature (March, 2000):
77-114.
5. A study that shows that in Russia, Ukraine, Poland, Slovakia, and Romania
bureaucratic corruption is strongly associated with firms hiding output from
the authorities is Simon Johnson, Daniel Kaufmann, John McMillan, and
Christopher Woodruff, "Why Do Firms Hide? Bribes and Unofficial Activity
after Communism," Journal of Public Economics (June, 2000): 495-520.
6. See also in this regard Andrei Shleifer and Robert W. Vishny, The Grabbing
Hand: Government Pathologies and Their Cures (Cambridge, MA, Harvard
University Press, 1998), and Eric Friedman, Simon Johnson, Daniel
Kaufmann, and Pablo Zoido-Lobatón, "Dodging the Grabbing Hand: The
Determinants of Unofficial Activity in 69 Countries," Journal of Public
Economics (June, 2000): 459-493.
7. This position is presented in Patrick K. Asea, "The Informal Sector: Baby or
Bath Water? A Comment," Carnegie-Rochester Conference Series on Public
Policy (December, 1996): 163-171.
8. This argument appears in Dilip K. Bhattacharya, "On the Economic Rationale
of Estimating the Hidden Economy," Economic Journal (June, 1999): 348359.
9. Such arguments have been made in regard to comparing northern Italy and
southern Italy, as by Robert D. Putnam, Making Democracy Work: Civic
Traditions in Modern Italy (Princeton, Princeton University Press, 1993), and
also in a more abstract form using increasing returns and path dependency
arguments from complexity theory by Maria Minniti, "Membership Has Its
Privileges: Old and New Mafia Organizations," Comparative Economic
Studies (Winter, 1995): 31-47. In the sociology literature such arguments
have long been made regarding threshold levels in mass behavior, with
Mark Granovetter, "Threshold Models of Collective Behavior," American
Journal of Sociology (58, 1978): 1420-1443) providing a classic example.
10. Examples of this early literature include Edgar L. Feige, "How Big is the
13
Irregular Economy?" Challenge (January, 1979): 5-13, and Bruno S. Frey
And Werner Pommerehne, "The Hidden Economy: State and Prospect for
Measurement," Review of Income and Wealth (March, 1984): 1-23. This led
to arguments that welfare states were simply in a hopelessly frustrating
situation whereby their efforts to redistribute income would backfire as tax
revenues would fall, e.g. Manfred E. Streit, "The Shadow Economy: A
Challenge to the Welfare State?" Ordo Yearbook (35, 1984): 109-119.
11. A correlation coefficient between the size of the underground economy and
Gini coefficient in 1994 for 16 transition economies of .76 was found by
J. Barkley Rosser, Jr., Marina V. Rosser, and Ehsan Ahmed, "Income
Inequality and the Informal Economy in Transition Economies," Journal of
Comparative Economics (March, 2000a): 156-171. They also found a
correlation coefficient between changes in the size of the underground
economy and changes in Gini coefficients of .705, with both of these
correlations being significant in bivariate regressions. The Gini coefficient
varies between zero and one with higher values indicating greater inequality.
12. Details of these relationships can be found in J. Barkley Rosser, Jr., Marina
V. Rosser, and Ehsan Ahmed, "Multiple Unofficial Economy Equilibria and
Income Distribution Dynamics in Systemic Transition," Mimeo, Department of
Economics, James Madison University, Harrisonburg, Virginia, 2000b,
available at http://cob.jmu.edu/rosserjb. One important caveat to the
relationships reported in the text is that there is a problem with using the
cumulative decline in output as such because it is already distorted by
changes in the relative size of the underground economy, larger such
changes automatically increasing the size of that reported cumulative decline.
As reported in Rosser, Rosser, and Ahmed, 2000b, if one replaces the
cumulative decline variable with an adjusted cumulative decline that accounts
for the changes due directly to increases in underground economy, that
variable ceases to be significant, with the maximum rate of inflation becoming
more significant than the Gini coefficient, which remains very significant.
13. Despite the early literature, some studies have found that even in the nontransition economies tax rates on labor income may not be positively
correlated with the size of the underground economy, with such factors as the
complexity of the tax code possibly playing offsetting roles, as found by
Friedrich Schneider and Reinhard Neck, "The Development of the Shadow
Economy under Changing Tax Systems and Structures," Finanzarchiv N.F.
(50, 1993): 344-369.
14. A compelling discussion of this problem with a discussion of the positive
example of Poland is provided by Marshall I. Goldman, "Reprivatizing
Russia," Challenge (May-June, 2000): 28-43.
15. A classic example of using the currency demand approach to estimate the
size of the underground economy in the U.S. is Vito Tanzi, "The Underground
Economy in the United States: Estimates and Implications," Banca Nazionale
Lavoro Quarterly Review (December, 1980): 427-453. Schneider and Enste,
2000, op. cit. provide a thorough overview of various methods of estimating
the size of the underground economy.
14
16. For all countries except for Kyrgyzstan and Slovenia, the size of the
underground economy as a percent of GDP is from Johnson, Kaufmann, and
Shleifer, 1997, op. cit., who model electricity use as a function of GDP, with
the estimates for Kyrgyzstan and Slovenia coming from a study of household
consumption of electricity by Mária Lackó, "Hidden Economy-An Unknown
Quantity? Comparative Analysis of Hidden Economies in Transition
Countries,1989-95," Economics of Transition (8, 2000): 117-149. The Gini
coefficients and changes of these are from Rosser, Rosser, and Ahmed,
2000a, op. cit., which represent combinations of estimates from a variety of
studies. The cumulative decline in output and maximum annual inflation rates
are both from Stanley Fischer, Ratna Sahay, and Carlos Végh, "Stabilization
and Growth in Transition Economies: The Early Experience," Journal of
Economic Perspectives (Spring, 1996): 67-86, although the cumulative
decline in output number has been adjusted to account for misreporting due
to changes in the size of the underground economy. The economic freedom
and democratic rights indexes for 1994 are both from Peter Murrell, "How Far
Has the Transition Progressed?" Journal of Economic Perspectives (Spring,
1996): 25-44. The effective marginal tax rates on labor and capital incomes
are both from Lackó, 2000, op. cit. In some cases, the beginning or ending
years are not exactly 1989 or 1994, but the nearest available, given the data
sources.
17. Considerable doubts have been raised about the underground economy
estimates for Uzbekistan in particular, a nation with a long history of reported
corruption. See Marshall I. Goldman, "Comment on Johnson, Kaufmann, and
Shleifer," Brookings Papers on Economic Activity (2, 1997): 222-230.
Romania’s numbers may also be suspect due to structural changes in its
electricity sector, as may be Kyrgyzstan’s for the same reason.
18. See Michael Förster and István György Tóth, "Poverty, Inequality and Social
Policies in the Visegrád Economies," Economics of Transition (5, 1997): 505510.
19. See Commander, 1997, op. cit.