Chapter

8 Equity Issues in Policymaking in Transition Economies

Editor(s):
Ke-young Chu, Sanjeev Gupta, and Vito Tanzi
Published Date:
May 1999
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Author(s)
Grzegorz W. Kolodko

Introduction

The biggest challenge an economist can face is not answering a difficult theoretical question but introducing reforms and making the day-to-day policy decisions that will prove that a theory works. Often, however, the theory does not work. The next challenge, then, is to modify the theory or to keep trying to change the reality. Because in the real world, far from the ivory tower of academia and elegant models, political life is brutal. What matters is political power, not just logical arguments and statistical evidence. In a classroom or at a conference, it may be enough to be right and to be able to prove it in a scholarly way; policymakers, however, need a majority in the parliament and, more important, social and political support for reforms.

Equity issues in policymaking are difficult to resolve because they are linked not only to economic matters but also to social constraints and political conflicts. What is fair and what is not is more a matter for ideological or philosophical dispute, not mathematical models. Equity is always a concern of policymakers, especially in transition economies’ early years of systemic change and severe contraction.

This paper discusses first the characteristics of income distribution under the former centrally planned system, then the changes that take place during transition to a market economy. Expectations for income patterns and wealth distribution are examined, as is the issue of increasing inequality. This paper then reviews the policy options, evaluates transition’s impact on inequity and inequality, and concludes that although inequality inevitably widens during transition, policymakers must link income distribution and growth to sustainable development. The recent successful implementation of Poland’s transition strategy suggests that such a linkage is feasible.

Departure

Income distribution in Central and Eastern Europe was more equal under the centrally planned system than during the transition period, and more equal than in market economies. Among these economies of Central and Eastern Europe, however, inequality varied. Examining these countries’ Gini coefficients (reflecting here distribution of net disposable income) reveals some patterns. In the late 1980s, the Gini coefficient varied from a low of 20 (for the Slovak Republic), to 28 (for Uzbekistan), with most countries between 23 and 24 points. Compared with the advanced market economies, the countries of Eastern Europe—excluding the former Yugoslavia—had Gini coefficients of, on average, 6 percentage points less than Western European countries (Table 8.1).

Table 8.1.Income Inequality Indexes, Selected Countries, 1986–87
Gross EarningsNet Disposable Income
Gini coefficientDecile ratioGini coefficientDecile ratio
Czechoslovakia19.72.319.92.4
Hungary22.12.620.92.6
Poland24.22.825.33.0
Soviet Union27.63.325.63.3
Great Britain26.73.229.73.9
West Germany25.2
United States31.7
Australia28.7
Sources: Atkinson and Micklewright (1992); and Milanovic (1998).Note: For West Germany, data are for 1981; for the United States, data are for 1987.
Sources: Atkinson and Micklewright (1992); and Milanovic (1998).Note: For West Germany, data are for 1981; for the United States, data are for 1987.

If we apply the classification proposed for the Organization for Economic Cooperation and Development (OECD) by Atkinson, Rainwater, and Smeeding (1995), which is based on degrees of inequality, none of the former centrally planned economies would qualify as having high income inequality (Gini coefficient of 33–35), or even average income inequality (29–31). All of these economies would score either low (24–26) or very low (20–22). Hence, before transition, the dominant pattern of income distribution was relatively equal. If measured by the Gini coefficients in terms of distribution of disposable income, the situation was similar to that in Finland, Sweden, West Germany, the Netherlands, and Norway.

We must note, however, two systemic differences between centrally planned and free market economies, and their policy implications during the transition. The first difference is the primary nominal income distribution; the second, the income redistribution mechanism.

Regarding primary income distribution, in the socialist economies, the dominant state and collective ownership of the factors of production minimized the role of capital gains, profits, rents, and dividends. These types of individual income did play a marginal role, but only in countries with a significant private sector (Hungary, Poland, and the former Yugoslavia) did it influence households’ income distribution.1 Interest income, of course, was insignificant due to weak banking sectors and the lack of other financial intermediaries; wages and pensions accounted for most households’ disposable income.

Concerning the income redistribution mechanism, the wage systems and policies were centralized, and in only a few countries (again, Hungary, Poland, and the former Yugoslavia) did the market-oriented reforms allow for relatively greater wage dispersion. In Poland in the 1970s, the highest-to-lowest-wage ratio could not exceed 6:1, although for about 90 percent of the labor force, the actual wage ratio was 3:1. This strong social and political pressure for egalitarian redistribution of income heavily affected labor allocation and productivity. Furthermore, under the socialist system, the state pension system was directly linked to the wage system. Thus, pensions for the retired and social benefits for the disabled were proportions of salaries and mirrored the more or less egalitarian wage policy.

The redistribution of the primary nominal income in the socialist economies had three characteristics. First, basic goods and services were subsidized extensively. In Poland in 1980—the year of the largest working class protest ever held in a socialist country—the subsidies accounted for as much as 10 percent of national income. However, their distribution, although mainly to the poor, did not make real income allocation or in-kind consumption more fair. Subsidies were granted for goods and services with low income elasticity, mainly apartment rent and mass transportation. These subsidies targeted the lower-income groups (Cornia, 1996a) but also helped middle-income households because, for instance, the larger the apartment and the more often one traveled, the greater the subsidy.

Second, unlike in the market economies, taxation did not play an important role. Direct taxes were of marginal significance in income dispersion—they accounted for no more than 2 percent of gross salaries, and in most cases, there was no difference between gross and net income. The latter characteristic had important consequences and policy implications for transition to a new system.

Third, although shortages differed from country to country—in goods, intensity, and timing—they played a major role in the final distribution of real disposable income in all of these economies (Kornai, 1980; Kolodko, 1986; and Nuti, 1989). The “shortageflation” phenomenon—that is, vast shortages accompanied by an open, price inflation (Kolodko and McMahon, 1987)—strongly affected actual consumption. Income was often insufficient to acquire needed goods and services, so nominal demand could not be satisfied. Queuing, rationing schemes, parallel markets, forced substitution, involuntary savings, and corruption were common. True access to scarce goods and services sometimes had even greater significance than the nominal money income. Hence, it is impossible to evaluate the income dispersion based only on the data on money income dispersion. This legacy and point of departure for the new system have heavily influenced the expectations and changes in income distribution patterns in the postsocialist countries.

Expectations

Few doubt that one cause of the postsocialist revolution in the Central and Eastern European countries was a general conviction that income was distributed unfairly and unequally, contrary to political claims and the system’s ideological foundations. Although it is difficult to say whether people were more concerned about the level of their income or the way it was distributed, it is likely that the latter played a greater role in sparking the transition. The desire for fair and equal income distribution was very strong, and social dissatisfaction and political tensions were rising due to the growing disparity in real income.

Of course, there were other elements that helped push these countries toward a market-oriented economy. People felt dissatisfied in three roles simultaneously: as producers, they were disappointed that some of their efforts were wasted by mismanagement, stagnating output, and the lack of ability to compete; as consumers, they were irritated by the growing inefficiencies of the distribution system and the time they had to spend for shopping; and as citizens, they were dissatisfied by their inability to influence economic, social, and political changes. Combined, these three motives ignited the push out from a centrally planned economy toward a market system.

However, not only at the onset of the transition but even today, some do not want to move from relatively egalitarian socialism to less egalitarian capitalism.2 There is still considerable naïveté that the market regime will bring higher and more equitably distributed income.

Ongoing political debates and the exaggerated demonstration effect from industrialized countries have fueled unrealistic expectations. The excessive optimism among the new political class does not take into account these industrialized countries’ histories. Nonpoliticians are even more unrealistic. They have been told by the new elite that as soon as they get rid of the old system, the distribution of income will be more favorable. The best example of this thesis is the populist Solidarity movement in Poland.

Hence, at the beginning of the transition, there was the widespread conviction that this process would quickly bring both higher income and a fairer distribution of the fruits of a better-performing economy. As naive as this attitude is, it is still held, even among some professionals and leading politicians familiar with the economic and social realities. Optimism increased when five of the transition countries began accession negotiations with the European Union (EU) in March 1998, leading some to believe that the development gap between the transition countries and those in Western Europe would be closed within ten years or so.3 Unfortunately, it will take longer.

The gap is too large to close in one generation.4 Closing the institutional gap will take a long time, closing the development gap even longer. They can be closed only when the rate of growth in Eastern Europe is much faster than in Western Europe. Because of the severe collapse in output during the first eight years of the transition, the per capita GDP gap between these two parts of the continent has widened. To increase per capita GDP by ECU 300, a country with a per capita GDP of ECU 15,000 needs 2 percent growth, a country with ECU 6,000 needs 5 percent growth, and one with ECU 3,000 needs 10 percent.

Unrealistic expectations for quick transition results and world economic integration can be explained more by political, ideological, and psychological factors than economic ones, though many did fail to anticipate the high costs of structural adjustment and recession, which further increased social and political tensions. Political leaders assumed that price liberalization and the elimination of shortages would lead to more equal income distribution. In some countries, such as the Czech Republic and Russia, these leaders thought that privatization through free asset distribution would also improve income distribution, and vast circles of professionals and politicians believed that the reform of the transfer system, especially of pensions, would not widen income gaps but, on the contrary, narrow them. Nevertheless, for a number of reasons, this has not been the case.

Short-term results did contribute to more equal income distribution—for instance, price liberalization improved access to goods that had been in short supply. Politicians and the policymakers took advantage of this to improve their constituents’ standards of living. Soon afterward, however, other transition events, such as the severe contraction of real salaries and the rapid increase in unemployment, worsened income inequality and increased the number of poor.

Thus, the policy was, in a sense, to walk from one point of no return to the next. The clearest example of this can still be seen in Russia, where the gap between expectations and achievements has grown since the transition began. In Poland, this gap existed in the early stage of transition only, because the accompanying costs were too high, as we shall see; thereafter, policy design was more realistic (Poznanski, 1996; and Kolodko and Nuti, 1997).

In the early 1990s in Poland, there was indeed shock, but not much therapy. It was assumed that output (in terms of real GDP) would contract by as little as 3.1 percent; instead, it collapsed by about 12 percent in 1990 and by an additional 7.2 percent in 1991. During the same period, industrial output shrank by 40 percent (in real terms), leading to a steep drop in household income and to mass unemployment. Although the government promised that unemployment would not exceed 5 percent, by the end of 1993 it had reached 16 percent and was growing. Compared with a stabilization target inflation (in terms of CPI) of less than 1 percent per month, the year-end inflation was about 250 percent in 1990 and over 70 percent in 1991.

The greatest disappointment among populists in political parties of the left and the right was in privatization. The higher the expectation for an egalitarian mass privatization, the greater the disappointment. As in many other transition countries, the populist anticipation that postsocialism would evolve into a “people’s capitalism”—due to the wide, free distribution of denationalized assets—led to frustration.

Although many people did receive free shares, they sold or otherwise dispersed them quickly.5 Due to ongoing redistribution, the shares are now being accumulated by fewer individuals, who are oriented more toward entrepreneurship and accumulation of wealth than consumption. There is nothing wrong with this type of redistribution as long as the people are not misled by their leaders, emerging market rules are transparent, public interest is taken into account, and redistribution patterns contribute to sound development.6 Unfortunately, this has not been the case in all transition countries.

These countries also expected that the transition would bring a lessening of regional differences and tensions. In the former centrally planned economies, income levels and living standards differed significantly by region. The largest differences were seen in the Baltics, Russia and other former Soviet Union countries and the former Yugoslavia. The dismantling of those countries eased the regional tensions between the richest and the poorest former republics—for example, between Estonia and Tajikistan in the former Soviet Union, and between Slovenia and Macedonia in the former Yugoslavia. Other countries experienced conflicting expectations: people living in poorer regions expected a quick improvement in their standard of living; those living in richer regions expected to be forced to transfer part of their income to the poorer regions, which they have been quite reluctant to do. Such conflicting expectations have had significant policy implications. The larger the income gap at the outset of transition, the stronger these conflicts and the stronger the current tensions.7

Reality

Although income distribution varies among countries, all transition economies have some common features. Income inequality is increasing in these countries, as expected. The fluctuations in people’s income—first it fell, then it grew—and in its distribution have led to lifetime highs in income inequality. The greatest changes occurred during the early stages of transition: real income contracted significantly, but the pace of the contraction varied across income groups. Hence, in a few years, income shares have changed significantly.

From this perspective, Milanovic (1998) divides the transition economies into three groups. In the first, consisting of Hungary, the Slovak Republic, and Slovenia (with a combined population of 18 million), income distribution, measured by the quintile relations, has not changed. No quintile group gained or lost more than 1 percentage point, so the income shift did not occur among those groups but within them. The changes were rather minor: in Hungary, the Gini coefficient went up by 2 percentage points (from 21 to 23); in Slovenia, by 3 points (from 22 to 25). In the Slovak Republic, more equal distribution was observed in 1993–95 than in 1987–88, since the Gini coefficient fell from 20 to 19 points (Table 8.2).

Table 8.2.Changes in Income Inequality During Transition
Gini Coefficient (Income per capita)
1987–881993–95
Slovak Republic2019
Hungary2123
Slovenia2225
Czech Republic19271
Belarus23282
Poland26283
Romania23429
Latvia2331
Uzbekistan28433
Kazakhstan2633
Bulgaria23434
Estonia23352
Turkmenistan2636
Moldova2436
Lithuania2337
Ukraine23471
Russia24482
Kyrgyz Republic26553
Sources: United Nations Development Programme (1996); Milanovic (1998).Note: For most countries, the income category for 1993–95 is disposable income. In 1987–88, it is gross income, since, at that time, personal income taxes were small, as was the difference between net and gross income. Income includes consumption in-kind, except for Hungary and Lithuania in 1993–95.

Monthly.

Quarterly.

Semiannually.

1989.

Sources: United Nations Development Programme (1996); Milanovic (1998).Note: For most countries, the income category for 1993–95 is disposable income. In 1987–88, it is gross income, since, at that time, personal income taxes were small, as was the difference between net and gross income. Income includes consumption in-kind, except for Hungary and Lithuania in 1993–95.

Monthly.

Quarterly.

Semiannually.

1989.

In the second group, which consists of Belarus, the Czech Republic, Latvia, Poland, and Romania (with a combined population of 84 million), there was a moderate worsening. Maximum declines were within the range of 1 to 2 percentage points and occurred only toward the three lower quintiles. At the same time, the gains of the top quintile varied from about 6 points (for the Czech Republic and Latvia) to below 2 points (for Poland). Thus, only the highest quintile benefited, and only in terms of the share of income. Due to the severe contraction, the absolute level of real income declined in all quintiles, although the higher the quintile, the lower the decrease. In this group, the Gini coefficient rose by only 2 points in Poland (from 26 to 28) but by a significant 8 points in the Czech Republic (from 19 to 27).

In the third group, which consists of Bulgaria, Estonia, Lithuania, Moldova, Russia, and Ukraine (with a combined population of more than 220 million), the changes were much greater. The income decline of the bottom quintile was 4 to 5 percentage points, and the second and third quintiles lost similar margins of their earlier share. In Russia, Ukraine, and Lithuania, the fifth quintile gained as much as 20, 14, and 11 points, respectively. The greatest shift occurred in Russia, where the bottom quintile share of income was halved—from 10 percent to 5 percent—while the top quintile jumped from the relative high of 34 percent to as much as 54 percent. The Gini coefficient increased by 11 points in Bulgaria, and doubled in Russia and Ukraine, jumping from 24 and 23 to 48 and 47 points, respectively (Figure 8.1).

Figure 8.1.Absolute Changes in Gini Coefficient in Transition Economies, 1987/88–1993/94

Sources: Author’s calculations, based on data provided in Milanovic (1998).

At the end of the first five years of the transition, income in the first and second groups of countries was, on average, still distributed more equally than in the market economies. In the third group, however, especially in the Baltics, Russia, and other former Soviet Union countries, income was distributed less equally than in OECD member countries.

Lately, the process has taken another route. Although in most of these countries income inequality has continued to grow—albeit at a much slower pace than before—in a few, it has stabilized. In recent years, this inequality has hovered around the dispersion structure that resulted from the changes that followed the earlier shocks. Of course, the income of some households and professional groups still fluctuates, but the changes are not as remarkable as they were in the first half of the decade—that is, they no longer fluctuate between quintiles and deciles.

These observations, however, must be made with caution. Although the transition economies are going through a vast, intensive process of liberalization, they still lack sophisticated market institutional arrangements. Thus, a common feature is an extensive shadow economy, consisting of unregistered economic activities, the income from which is significant but impossible to measure. The shadow economy, which analysts estimate contributes from 15 percent to 50 percent of GDP in these countries, does affect inequality.8

Because there are many types of unregistered activities, the real challenge is to find the most appropriate way to institutionalize the shadow economy. Whereas some activities should be eliminated, others should be made official in a controlled way. Although the parallel economy includes organized crime, which has to be fought, it is primarily composed of many small-scale businesses in many sectors—sectors that produce goods and provide services, jobs, and income.

In transition societies, many are keen to take their fate into their own hands; however, they are less eager to register their activities and pay the related taxes and social security contributions. Changing such attitudes will take time. For now, this emerging entrepreneurship, which creates a reasonable source of income, should be tolerated and gradually incorporated into the official economy by various “stick and carrot” methods. Before this task is accomplished, however, a significant amount of income will be made in the shadow economy, and simultaneously, a significant part of total income will be redistributed through the parallel sector. These corrections in the dispersion pattern definitely complicate the picture drawn from the analysis of data on official income distribution alone.

At the lower end of the income spectrum, many households engaged in the shadow economy, particularly in the trade, housing construction, maintenance, and some traditional service sectors, have higher income than is recorded formally in the household budget survey (HBS). Although most—if not all—of the unemployed are officially counted in the bottom quintile, some should instead be counted in the second, at least. At the higher end of the spectrum, the official picture may be biased even more, because many activities of the new entrepreneurial class are not recorded at all. Using various means, they are often able to conceal from the tax officials a significant part of their actual income. Both tax evasion and tax avoidance are widespread in transition economies, primarily owing to poor tax administration and the low moral standards of some emerging capitalists. Whereas the creation of effective fiscal order and an efficient tax collection system is a long-term process, taxation is often treated as a sort of punishment. Many believe that taxation limits the business sector’s ability to expand; taxation is rarely seen as a fair and rational instrument of income redistribution.

The range of the informal sector, with all its merits and drawbacks for income dispersion, depends on maturity of institutional arrangements, on the one hand, and developments in the real economy, on the other. In economies with relatively more advanced market institutions and a more market-oriented culture—for example, in the countries invited to begin their accession negotiations with the EU—the scope of tax evasion is much smaller than in the countries lagging behind. Although the informal sector is difficult to measure, it seems reasonable to claim that the shadow economy is larger in Ukraine than in Poland, larger in Armenia than in Latvia, larger in Romania than in Hungary, and larger in Croatia than in Slovenia.

As for developments in the real economy, the tendencies are mixed. In the fast-growing countries, at least part of the expansion is due to vigorous activities in the parallel economy. As output rises, more people classified as jobless make ends meet by working in the shadow economy than by collecting the dole, and weak regulations allow business communities to hide at least part of their growing revenue. In transition countries with continuing recession, an increasing number of people are looking for an opportunity to earn money wherever they can, including in the shadow economy, but they have fewer opportunities than in a growing economy.

The outcome of what has happened thus far can be only roughly estimated. Analysts have recognized that the shadow economy contributes to the higher income of all social strata, but it is impossible to estimate precisely how it influences the final proportions of disposable real income. Although the informal sector contributes to higher production and welfare as a whole, it also transfers part of the income from some households to others. Because one cannot map these income flows, one can only draw general conclusions. It is not a zero-sum game. Income redistribution conducted within the parallel economy—as well as between the parallel and the official economy—can enhance overall growth. Thus, in the long run, it can contribute to a higher standard of living for the whole society. It seems, therefore, that the parallel economy, through its contribution to actual national income, and its impact on redistribution, raises inequality. Moreover, in the transition economies, as in the less-developed market economies, the difference between the official and the true picture of income distribution—if one takes into account the shadow economy—is much greater than in the more developed market economies.

Mechanism

The income distribution pattern has changed qualitatively during transition. Events and processes of vital importance have resulted from abandoning many fundamental features and rules exercised under the centrally planned regime. In spite of considerable confusion as to what impact these political, institutional, and structural changes would have on equity issues, the mechanism of change has been irreversibly set in motion.

Particularly important is that a majority of the subsidies and allowances—previously provided by the state to some groups to support their consumption in kind—have been radically reduced or eliminated completely. Since the beginning of the transition, removing subsidies has been seen as absolutely necessary by various international organizations, especially by the IMF. The IMF was willing to back only structural adjustment policies that led to the liquidation of all subsidies. This external pressure was mixed with domestic tugs-of-war between the countries’ political extremes, that is, between the old left and the new right populists on one side, and the free market zealots on the other.

Depending on the social and political situation as well as on the chosen path of price liberalization and adjustment, the way the subsidies were removed influenced income dispersion. The more radical the subsidy cuts, the deeper the shift in income inequality. Whereas some shortages did indeed disappear rather quickly (the shops were full of goods), the real income and money balances of households shrank even faster (because consumers’ pockets were almost empty). Consequently, slashing subsidies and liberalizing prices did ultimately contribute to an improvement of the fiscal stance and to the introduction of a market-clearing mechanism, but these were achieved at the cost of growing income inequality.

Setting aside the way the subsidy-removal policies have been executed in some countries, this approach should pay off in the longer run.9 The transparency of free market rules, the efficiency of market-clearing pricing and its influence upon the allocation of resources, as well as the liquidation of distribution pathologies related to the shortageflation syndrome, have contributed to improving economic performance and increasing competitiveness. If not now, then in the foreseeable future, these reforms will be fruitful for all people in the transition countries and will make these countries more competitive internationally.

In the meantime, however, price liberalizations and far-reaching subsidy reductions—the unavoidable part of transition—have been causing high inflation. This was the case in Poland in 1989–93, it is still an issue in Bulgaria and Romania in 1997–99, and it will be a serious challenge in Belarus and Ukraine in 1999–2001. Whether such inflation is corrective or not does not matter for income redistribution. Often, the basic cost of living—the price of food, housing, utilities, and public transport—rises first and the most; later, partial commercialization (e.g., marketization) of other basic services, including health care, leads to further increases in the cost of living.

Inflationary income redistribution—executed through real income cuts of different magnitudes for each household group—significantly increased income inequality in the early 1990s. This process is far from over in countries less advanced in liberalization and stabilization (Belarus, Bulgaria, Macedonia, Romania, and Ukraine, and especially in Kazakhstan, Turkmenistan, and Uzbekistan).

With extremely high inflation, real income distribution had depended on the indexation procedures used at the time of the stabilization policy. Although the desire to stabilize the economy called for much faster growth of prices than wages—or other income, such as pensions—and hence a larger drop in the real income, social expectations and political pressure pushed the governments toward more lenient downward adjustments. Against this background, the actual indexation was always a function of political compromise and did not necessarily reflect economic arguments. Some social and professional groups bargained harder for compensation than others. For instance, it was easier for workers—especially in the large industrial centers—than for teachers or paramedics to get more compensation for the growing costs of living.

Because of this unequal indexation, inequality continues to fuel social tensions (Gregory, 1997). Since that problem is far from solved in any transition economy, the ongoing changes in relative wages between certain groups, regardless of their contributions to the national welfare, will continue to cause political friction. However, in terms of inequity, these changes will not cause significant changes in the existing pattern of income distribution, only in the relative position of some professional groups vis-à-vis others.

Another aspect of inflationary redistribution that affects equity and equality is one related to household savings. Because of the shortages under the centrally planned system, there was always some disposable net income that could not be spent on desired goods and services. This set in motion forced substitution and boosted the parallel, often semilegal, or black markets. Even so, households were left with some residual, “disposable” income that was involuntarily saved. When structural adjustment arrived—together with the post-socialist revolution—prices were freed and raised to the market-clearing level. The purchasing power of these saved money balances, including those held in banks, however, was only partially protected. They were indexed, but only to some extent.10

The extent of the indexing depended on the stabilization program and, of course, took into account the situation within the banking sector. Indexation was rather awkward, and when considered with the worsening stance of public finance and the state budget, it did not allow for full compensation; therefore, people’s savings depreciated significantly. Only the most flexible, well-informed, and entrepreneurial households were able to protect the real value of their savings. In some of the more successful cases, these savings became the seed capital for future businesses.

In sum, many people lost part of their lifetime savings, although a few were able to convert these holdings into capital and multiply them on the wave of liberalization and the accompanying corrective inflation. This course of events deepened income inequality in the postsocialist societies (Kolodko, 1992a); in a direct way, it impacted solely on the savings accumulated in the past, but indirectly it has influenced current income and savings as well.

Economic reforms liberalized wage setting in the state sectors.11 Regardless of the initial pace of denationalization, by the mid-1990s, in most transition economies, more than half the labor force earned their salaries in the state sector. Whereas under the socialist system, due to ideological and political constraints, the dispersion of wages was quite limited, a much wider dispersion has been accepted during the transition, and income has become more tightly linked to qualifications, experience, occupation, and performance. Thus, the transition has meant a closer relation between an individual’s past investment in human capital and his or her current remuneration, which has led to greater wage dispersion (Cornia, 1996a). Because the quality of human capital varied more than did salaries under central planning, the later realignment of wages with levels of human capital has increased income inequality. It may, however, be claimed that income equity increased as well—for both blue-collar and white-collar workers.12

Even more significant for rising income inequality is the shift of labor from the state to the private sector. Not only is the dispersion of wages in the latter larger than in the former, but the average income earned is higher. This is due mainly to the higher labor productivity in the private sector; the state is in control of a number of obsolete, noncompetitive industries and poorly managed, relatively low-paid services, such as education, health care, and central and local administrations. Because of meager budgets, these sectors have not been able to compete with the remuneration provided by industries performing profitably on a commercial basis. Therefore, the rising share of labor engaged in the rapidly growing private sector has heightened income inequality. This outcome merely reflects the accommodation of the market to the higher quality of labor engaged in these activities. Nevertheless, in transition economies, to the extent that the labor market is still quite rigid and far from perfect, the salary ratio remains somewhat distorted.

When an economy moves from a centrally planned to a free market system, the most revolutionary and fundamental changes take place in asset ownership. The basic features of the beginning of capitalism are denationalization, privatization, property restitution, participation of foreign direct and portfolio capital, and the development of financial intermediaries to accompany private sector expansion. These events strongly affect income distribution.

During transition, the share of wages in total income decreases, while that of capital gains—for example, profits, dividends, interest, and rents—increases. The transition process itself as carried out in the 1990s has contributed significantly to growing inequity as well as inequality. Market reforms inevitably result in some unjustified redistribution—an unavoidable byproduct of the transition process—which can be limited through sound policies but not contained entirely.

The fundamental shift of assets from state to private hands has been followed by a similar shift in the income earned on these assets. Obviously, these changes in the economies under discussion have also increased the inequity and inequality. In general, authorities make choices about how the property rights transformation is to be designed and by what means it will be managed. The two extreme options are to sell state property to any investor, especially a strategic one, at the market-clearing price,13 and the “Utopian” option—to freely distribute all assets among eligible citizens.14 Of course, in the real world, some combination of these two extremes is needed. Hungary chose a path closer to the first option; the Czech Republic, closer to the second; and Poland, between the two.

The implications for corporate governance and microeconomic efficiency differ by option, but so do the consequences for income inequality in the long run. And the choice between the two options is not simple. More unequal privatization—selling to strategic investors—favors competitiveness and hence the income level; more egalitarian distribution of assets favors income equity but does not necessarily improve efficiency.

The populist mainstream in both economics and politics has suggested that mass privatization through the free distribution of shares can offset the hardship caused by structural adjustment, especially growing unemployment and falling real earnings and pensions. This may be true, but only to some extent and only as temporary compensation for lost income. In fact, in several countries, workers have gone on strike—not against privatization but in favor of it. These strikers have not been zealots of capitalism and a free market; they just wanted quasi-money—the shares, vouchers, certificates, or coupons entitling them to what they felt was rightly theirs. However, it seems bizarre that a poor person would have no access to an adequate social safety net yet own shares of a privatized enterprise. This poverty and lack of social protection did not accord with the vision of market economy under “people’s capitalism”; furthermore, it barely reduced the inequality and resulting tension.15

The problem of equity and equality versus inequity and inequality is even more serious. The basic problem is not the change in the income distribution pattern in, say, 1990–99—although for some 15 percent of the population these were the last years of their lives—but the irreversible foundation that has been laid for income distribution in the future. This change is the result of the stormy and indeed badly regulated and controlled process of asset distribution linked to the privatization process. In other words, when some were fighting for more fair indexation of their modest income (e.g., the current flow), the more cautious were trying to acquire as much property as possible (e.g., stock, or future income).

In conclusion, taking only the flow of income into account, one cannot accurately answer the question about the scope, direction, or pace of inequality. Those that are rich (owning many assets) may report very little income, whereas others—including the relatively poor—may have to pay the highest possible taxes. To measure inequality properly in post-transition economies, one must analyze not how the flow of income is dispersed, but how it is distributed and how the stocks of denationalized assets are divided. Otherwise, one sees a distorted picture—only part of the movie screen. Unfortunately, there is not even a rough statistical basis for such considerations. Most income flows are registered, but asset transfers are not.

The introduction of comprehensive taxation systems has changed the income distribution mechanism and its final outcome. Fiscal order in transition countries is not yet the same as in the mature market economies. The personal income tax—for some countries, entirely new—is always progressive, although the brackets and scales vary among countries. Because higher income is taxed at a higher margin, taxation decreases the gap in net disposable income between better- and worse-remunerated people and, subsequently, narrows the scope of inequality.

In transition economies, the fiscal regimes and policies are not stable and hence neither is the equalizing effect of fiscal policy. There are continuous debates and political battles between the parties on raising and lowering taxes. Again, the true system is never a masterpiece of public finance theory and policy, but always a political compromise.

In spite of these reservations, redistribution does, at least to some degree, contribute to an impartial correction of the primary income distribution. As the market is in the process of being built, it cannot, of course, distribute national income in a way that guarantees both the fair participation of specific groups in the flow of current wealth and its future growth.

What makes transition countries truly different from advanced market economies is that, in most cases, capital gains are not taxed at all. As they are not taxed, they are not recorded. Or is it the other way around? This approach has serious policy implications, but regarding the fiscal system’s impact on equity and equality, the lack of capital gains taxation definitely increases inequity and inequality.

Policy

The heart of the transition matter is to change a stagnant, former centrally planned economy to a market economy that can expand and compete internationally. Other issues, including income and wealth distribution, are often seen as secondary goals of economic and social policies, or simply as byproducts of the systemic changes. Besides, the redistribution of income can be treated as simply a means of furthering accumulation of wealth. And such accumulation, in turn, should create a foundation for the new middle and upper classes, without whom the market system cannot exist. In fact, in transition economies, one can observe the frantic process of wealth accumulation, which can be called “postsocialist primary capital accumulation.” If not immediately then soon thereafter, people get the message that capitalism cannot be restored or created without capital and capitalists—and the inherent consequences for inequity and inequality.

The conclusion is obvious. During transition, inequality must rise, and policymakers should try to shape such inequality in a way that facilitates the transition’s goals. Thus, the challenge is, first, to define and design this line of policy, and, second, to implement it in the best possible fashion. This is not easy, and it may be even more difficult than it was in the past during periods of primary accumulation, because now it must take place during a severe transitional recession.

Whatever the explanation for the great postsocialist slump,16 the fact remains that the officially registered GDP of 25 countries in Eastern Europe, the Baltics, Russia, and other former Soviet Union countries has contracted by almost 30 percent (weighted average) in the first seven years of transition. Only in the eighth year—in 1997—was a modest recovery recorded, albeit not in all countries involved (Table 8.3).17

Table 8.3.Recession and Growth in Transition Economies, 1990–97
Countries1997 GDP Index (1989=100)RankingNumber of Years of GDP DeclineDid GDP Fall Again After Recovery?Average Annual Rate of GDP Growth
1990–931994–971990–97
Poland111.812No–3.16.31.6
Slovenia99.323No–3.94.00.0
Czech Republic95.833No–4.33.6–0.4
Slovak Republic95.644No–6.86.3–0.3
Hungary90.454No–4.82.5–1.1
Uzbekistan86.765No–3.1–0.3–1.7
Romania82.474Yes–6.42.1–2.2
Albania79.184Yes–8.84.9–2.0
Estonia77.995No–9.74.1–2.8
Croatia73.3104No–9.93.0–3.4
Belarus70.8116No–5.4–2.6–4.0
Bulgaria62.8126Yes–7.4–3.6–5.5
Kyrgyz Republic58.7135No–9.3–2.4–5.8
Kazakhstan58.1146No–6.7–6.0–6.3
Latvia56.8154Yes–13.82.2–5.8
Macedonia55.3166No12.90.8–6.9
Russia52.2177No–10.1–5.3–7.7
Lithuania42.8185No–18.30.5–8.9
Turkmenistan42.6197No–4.5–15.0–9.8
Armenia41.1204No–21.45.4–8.0
Azerbaijan40.5216No–14.5–5.7–10.1
Tajikistan40.0227No–12.2–8.4–10.3
Ukraine38.3238No recovery–10.1–12.1–11.1
Moldova35.1247No–12.6–10.2–11.4
Georgia34.3255No–24.12.9–10.6
Source: National statistics; data from various international organizations; and the author’s calculations.
Source: National statistics; data from various international organizations; and the author’s calculations.

From social and political points of view, it is a challenge—and rather risky politically—to allow for any meaningful shift of income from the bottom to the top quintile, even at the time of robust growth. Certainly, it is much more difficult to do so during a period of collapse in output. For the transition, such a collapse has been the case for a number of years. Therefore, in considering the issue of inequality, one has to distinguish between the stages of contraction and growth.

Contraction has lasted from a relatively short period of three years in Poland to nine years in Ukraine.18 In some countries—and not only those experiencing regional conflicts—it may continue for some years. While the average income is on the decline and policy favors promotion to the new middle class, poverty must also be increasing. During the period of contraction, the redistribution mechanisms transfer additional portions of already falling income from the poorer parts of society to the richer.

This is the picture as seen from a macroeconomic perspective. On the microeconomic level, however, the changing pattern of income flow reflects mostly the shift in certain population groups’ contributions to GDP. Unfortunately, this product has been shrinking for several years. The poor are getting poorer because their contribution to declining national income is falling faster than the contributions of other groups. The shorter this extremely difficult period, and the smaller the fall in output, the better. It may be argued that both the scope and the length of the transitional recession—which is, to some extent, unavoidable—could be reduced (Kolodko, 1992b). Hence, the first general conclusion is that in addressing the issue of inequality in transition countries, one must try to limit the scope and length of the recession as much as possible. Avoiding a recession is not possible, but counteracting it is necessary.

Sooner or later, the transition economies will grow. After all, the whole exercise is motivated by a commitment to bring them into the global economy, as open markets expand much faster. The World Bank (1997) estimates that the transition economies could grow in a quarter of a century (1996–2020) by as much as 5.8 percent annually. Although that may seem impossible—especially in light of the weak performance of 1996–97, which showed almost no growth at all—some countries may achieve even more; it depends on the quality of the policies. With sound fundamentals, proper institutional arrangements, active involvement of the redefined state—and some luck—it may happen.

Recently the leader in the transition, Poland, has enjoyed a remarkable rate of growth. Under a properly fashioned program known as the Strategy for Poland (see Kolodko, 1996; OECD, 1996), which covers both transition and development, the economy has moved from early “shock without therapy” to “therapy without shock.” Not surprisingly, in 1994–97, Poland recorded a GDP growth of about 29 percent, or 6.3 percent annually on average. This growth was accompanied by further progress in institutional advancement, which brought Poland to OECD membership in the summer of 1996 and, together with four other Eastern European nations, to EU accession negotiations in 1998. At the same time, further progress toward the consolidation of stabilization has been accomplished. Inflation fell threefold, from 37.7 percent at the end of 1993 to 13.2 percent at the end of 1997; the unemployment rate declined by more than one-third, from 16.4 percent to 10.5 percent; and the fiscal-deficit-to-GDP ratio was halved, from 2.8 percent to only 1.4 percent.

When an economy is on the rise, the issues of inequity and inequality can be addressed in a different way. During a recession, the questions are: How can the loss of income be shared? How can a particular social group bear the burden of its decline? Under an expansion, the questions change to: How should growing income be distributed? How should the increase in national income be divided among population groups? Even in the most advanced market economies, policy affects how income is shared, as it cannot be left exclusively to spontaneous market forces. And more so in transition countries, where the market forces are, by definition, in their infancy. The best policy guideline for the government is to intervene only to the extent that guarantees a compromise between the interests of particular income groups and provides sufficient incentives for capital formation to facilitate development and hence growth in the standard of living for all (Tanzi and Chu, 1998).

One group that is definitely gaining from recovery and growth includes those who have found jobs. In Poland’s case, unemployment peaked in the summer of 1994 at close to 17 percent, or almost three million people. By the end of 1997, because of an active employment policy that took advantage of both directed subsidized credit and fiscal instruments, joblessness fell by one million. These million people and their families improved their absolute and relative income positions and thus the previous income inequality was mitigated. Hence, the second general conclusion is that only a policy that lowers unemployment can reduce inequality.

The income policy as well as the asset redistribution policy must facilitate the accumulation of capital, which is mainly the domain of richer people. During a period of strong growth, it seems to be easier to accomplish this target because the two policies benefit each other—although only in the medium and long term. Growth facilitates capital formation, and vice versa, capital formation favors growth. If these interrelations are set in motion by the policy instruments and events in the real and financial sectors, then it is easier to get society’s approval for such policies.

In transition, if some are getting richer while others are getting poorer—which is unavoidable during periods of contraction and thus increasing inequality—there is no way to convince the latter that they are better off.19 However, the poor who become a little less so—because those who are richer contribute to overall growth—tend to accept their situation. It is possible that on such a path, the income dispersion will increase even more. Nevertheless, if the increase in the wealth of some does not occur at a cost to others, these changes are likely to be accepted by most of society.

These attitudes can be seen in the public’s reaction to changes in the standard of living and income distribution in two distinct transition economies. One seems to be a success story; the other one is, so far, a failure. In the first country, Poland, the percent of households that assess their situation as “good or very good” is slowly but steadily growing: it rose from a single digit in the early 1990s, to 12.2 percent in 1995, and to 13.1 percent in 1997.20 This change in public opinion reflects both the growth of absolute income as well as greater acceptance of changes in the income distribution pattern. So, not only has the reality changed but the public’s perception of it as well.

In the second country, Russia, the public is convinced—and not without cause—that transition has brought a plague of corruption and “crony capitalism,” which are related to the continuing recession, growing inequality, and spreading poverty. Even the country’s leading politicians and international organizations have admitted this on several occasions.21 Consequently, the Gini coefficient doubled in the first five or six years of transition and will likely rise further. The growing arrears on unpaid salaries and pensions, on the one hand, and the accumulation of wealth from insider privatization, lucrative financial market deals, and—especially—pervasive organized crime, on the other hand, have contributed to the increasing income inequality. Both reality and beliefs are reflected in the very discouraging public opinion polls. When between 80 percent and 90 percent of society is convinced that wealth accumulation depends on connections or dishonesty and that poverty is a result of the economic system, then the future does not look bright (Table 8.4).

Table 8.4.Russia: Placing the Blame(Percentage of respondents agreeing to each cause)
What are the causes of poverty?
Economic system82.0
Laziness and drinking77.0
Unequal opportunities65.0
Discrimination47.0
Lack of effort44.0
Lack of talent33.0
Bad luck31.0
What are the causes of wealth?
Connections88.0
Economic system78.0
Dishonesty76.0
Opportunities62.0
Talent50.0
Luck42.0
Hard work39.0
Source: Survey by Interfax-AIF of 1,585 respondents (Moscow, November 1997).
Source: Survey by Interfax-AIF of 1,585 respondents (Moscow, November 1997).

In contrast, in Poland—due to the robust growth initiated by the Strategy for Poland and an income policy aimed at achieving more fair distribution—the Gini coefficient has stabilized in recent years. According to an OECD study, it grew from about 25 percent in 1989 to about 30 percent in 1994, then declined slightly to 29.4 percent in 1995 (OECD, 1996). Estimates show that the Gini coefficient has since remained around this level or has increased only slightly in terms of wage dispersion, but that it has increased rather substantially in terms of income per capita (Figure 8.2).

Figure 8.2.Poland: Gini Coefficients During Implementation of “Strategy for Poland”

Sources: Gini coefficients for wages: Rutkowski (1997); Gini coefficients for per capita income; estimates by Dr. Irena Topinska, University of Warsaw, 1997.

Likewise, the ratio of top to bottom deciles increased to 3.03 in 1993 and 3.36 in 1994; since then it has stabilized or risen by only a small margin. More meaningful changes have occurred within the top decile, owing to wealth accumulation by the richest, but the actual income for the top decile is unknown (World Bank, 1995). One must be careful in drawing conclusions from these observations. Particularly at the upper end of the top decile, the picture can be seriously distorted, and the difference between the decile (or quintile) ratio for wages and for overall income seems to be significant (see Figure 8.3).

Figure 8.3.Poland: Decile Ratio for Wages, 1993–96

(Ratio of highest to lowest 10 percent of wages)

Has this recent drive toward more equitable income distribution in Poland been just a coincidence or the result of a deliberately chosen policy? Both. On the one hand, the market forces set in motion by the transition changed the distribution mechanism (Cornia and Popov, 1997). Developing economies with fast-expanding private sectors and the restructuring state industries have been able to provide growing income for all social strata. As far as the decile groups are concerned, since 1995, their gains have been rather proportional.22 On the other hand, a decision was made—and became a fundamental part of the Strategy for Poland—that fairer income distribution should be not only the autonomous policy target but also an instrument to facilitate further growth.23

At the beginning of the transition, the shift of labor from the state to the private sector quickly caused an increase in wage inequality. This worsened when discriminatory measures were used against the state sector. Tough, if not overly restrictive, wage-based taxation was used to contain nominal salaries; this was an essential instrument of anti-inflation policy at this stage. Later, especially in 1991–93, the famous Polish popiwek (the wage-based punitive tax), was used exclusively as leverage on state companies to push them toward privatization. Although the popiwek served this purpose, it also led to increasing income disparity and hampered the motivation for labor productivity growth in the public sector.

When the popiwek was finally abandoned at the beginning of 1995, state sector output soared. As a result, the growth in the income of the workers employed in this sector was on a par with the growth of remuneration in the private sector. Thus, the third general conclusion is that it is unwise to use a punitive measure that favors one sector at a cost to another even if it accelerates privatization, because it may slow the rate of growth and stifle competitiveness not only in the state sector but throughout the economy. If such a measure is used, inequality will rise and growth will slow in the medium term.24

Another important challenge was related to income policy at the initial stage of structural adjustment in an inflationary environment. In 1990, at the beginning of the stabilization, attempts were made to contain aggregate demand by cutting civil servants’ wages by a larger margin than the fall in the remuneration of industrial workers. Later, the objective was to increase more quickly the average compensation to civil servants. This move was based not only on the conviction that such compensation was fairer but also that this type of investment in human capital would contribute to higher growth in the long term, as well as strengthen the relationship between investment in human capital and earning levels, which was rather weak prior to, and at the beginning of, the transition. Therefore, the fourth general conclusion is that, although the regulation of commercial sector wages should be left basically to market forces, the state should keep civil servant remuneration and the average industrial wage at a ratio that is socially acceptable and facilitates the development of human capital. The other elements of fiscal policy should serve this purpose as well.

A further shift in policy was linked with the difficult issues of indexation of pensions and benefits for the disabled. At the beginning of the stabilization, pensions were indexed to nominal wages, not to the cost of living. This was another serious policy mistake, since the solution was short-lived (Kolodko, 1991). This indexation was based on the assumption that real pensions should follow the path of wage adjustment—there should be a steep fall in real wages and a simultaneous deep contraction of real pensions.

However, as wages began to increase, owing to growing labor productivity, so did pensions, despite the lack of financial resources to pay for such an increase. Because the government was forced to borrow to finance the expanding fiscal gap, the commercial sector was crowded out of the credit market. This, in turn, acted against potential growth. It would have been much more reasonable to first decrease real pensions by less than the drop in wages than to allow them a smaller growth in real terms. Afterward, it turned out to be extremely difficult to adapt the indexation rules to the new circumstances, which had serious consequences for the public finance stance and delayed the social security system reform.25

In 1996, modification of the indexation rules allowed for real pensions to be adjusted upward yet kept within the limits of noninflationary financing; this has led to only a moderate increase in the ratio between average salaries and pensions. Considering the very high dependency ratio, these reforms did not significantly change the income dispersion.26 Contrary to popular belief in Poland, only about 15 percent of retirees are poor or worse off than the working class.27 Therefore, most pensioners are actually in the second or third quintile, a fact sustained by the new indexation rules, which allow for a modest growth in their purchasing power.

Crucial to the success of transition and development is a capital formation policy. It is assumed that a market economy, unlike a centrally planned economy, will be characterized by a greater ability to save and a more efficient allocation of capital. In the past, however, the severe output collapse caused a substantial decline in the propensity to save and the emerging postsocialist markets were caught in the trap of a serious capital deficit. Although the inflow of foreign savings is important, especially long-term capital and preferably as direct investment, domestic savings are even more so.

During transition, income policy must deal with many contradictions. Although the drive to encourage saving suggests more lenient taxation of some types and sources of income, growing inequality suggests the opposite. How to resolve this tension between the two objectives is a matter of policy options. If the economy is expected to recover quickly and expand, then some fiscal preferences for capital gains have to be introduced. This option is politically difficult, not only because of quite strong populist temptations in the postsocialist societies as well as among influential politicians, but also because it is strange to tax unemployment benefits or minimal pensions yet not capital gains on speculation, for instance, on the stock exchange.

In transition economies, such policies are often exercised to encourage saving. The capital gains from, for instance, the appreciation of stock, interest on bank deposits, and dividends on shares are often free of taxation or taxed only modestly, with a view to promoting capital formation and increasing national saving.28 Of course, this approach increases inequality, but also—through saving and investment—facilitates growth and, hence, the standard of living of the entire nation.

At the beginning of a transition, especially during a contraction, the above-mentioned capital formation policy works for only the more affluent, namely, those who have some disposable income that can be saved and invested. Later, when the economy is on the rise and more social strata are enjoying growing real income, the expanding capital markets and better-performing financial intermediaries, together with a preferential fiscal policy, encourage further saving. Consequently, the size of the emerging middle class increases and the poorer parts of society are able to save a growing percentage of their earnings.

As expected, this policy was quite controversial in Poland. In late 1992 through 1993, the lack of taxation on gains from stock speculation and a general euphoria led to an expanding bubble in the capital market. This situation—typical for emerging markets—was fueled by the frantic mass media. Because the rate of return—although not sustainable—was extremely high, demands for the taxation of extraordinary profits earned during a period not that favorable to the overall economy seemed to be justified. Unfortunately, no corrective steps were taken until it was too late—the bubble burst at the beginning of 1994. The stock exchange index declined by some two-thirds, at which point there was no reason to tax this type of capital gains. For a couple of months, a rather neutral turnover tax was imposed on short-term stock exchange transactions, but it was soon eliminated.

In 1996, the Polish government adopted Package 2000, a program aimed at sustaining growth. Under this program, capital gains remain tax free at least until the end of 2000. Between 1993 and 1997, national savings increased by about 4 percent of GDP, mostly from higher domestic savings. If such actions had not been taken, perhaps inequality would be slightly less but growth would not be as robust. Thus, the fifth general conclusion is that, if the policy alternatives are less inequality and a lower rate of growth versus greater inequality and a higher rate of growth, the choice should be higher growth and acceptance of a relatively higher income disparity. In the end, everyone will be better-off if this policy is chosen.

Package 2000 reduced corporate and personal income tax for all income groups. Prior to 1996, the corporate income tax was a flat 40 percent, but since 1997, it is being cut by 2 percentage points per year, to 32 percent in the year 2000 and afterward. These rate changes should enhance corporations’ ability to invest and, in the longer run, increase international competitiveness.

Package 2000 reduced the personal income tax in two steps.29 In 1997, each of the three brackets was lowered by 1 percentage point—to 20, 32, and 44 percent; in 1998, they were cut to 19, 30, and 40 percent.

Once again, there was a hot political debate on making these tax cuts. Strong opposition to the proposed cuts emerged in both the ruling coalition and among their political opponents.30 For the corporate tax, in government circles it was argued that it would be better to widen the existing system of tax deductions, which was aimed at promoting investment, than to lower the tax burden for all enterprises. Opponents argued that it would be better to give up the entire system of investment allowances and lower the tax rate even further.

As for the personal income tax, the leading argument of the parties supporting the government was that the proposal favored the richer part of society, providing them a nominal tax reduction of as much as 5 percentage points, whereas for the overwhelming majority of the population it would be only 1 point. But it must be remembered that personal income taxes had been raised previously by these very margins.

The attitude of the opposition liberal party was a bit strange. Although they declared their strong probusiness orientation, they simply did not want the tax reduction plan to be realized by a government led by the leftist party, which, according to their politically and ideologically motivated rhetoric, was supposed to be in favor of taxing and spending. Eventually, the reduction of the lowest bracket was made 2 percentage points, and some minor changes were made in deductions linked to investment in human capital, particularly in higher education. This scheme was accepted.

As for income distribution, these tax code changes may slightly raise inequality, especially the ratio between the top tenth and the other deciles. Although all taxpayers will gain from the reduction of the fiscal burden, the top decile will gain more than the other nine. Income dispersion and the personal taxation system in Poland work in such a way that only those in the top decile pay taxes in either of the two top rates (30 and 40 percent).31 Hence, their netincome increases more than that of the remaining 90 percent of society. The final results of these changes will not be known until after 1999, when the first year’s gross personal income and tax records are available.

In spite of the drawbacks, a capital gains preference policy does encourage savings. It also enhances people’s capacity to invest more in their human capital. Due to robust growth, real income was increasing; given an improvement in the fiscal situation, a tax reduction was feasible. From the macroeconomic angle, it is much less costly in terms of alternative budgetary revenue to cut the upper tax bracket than the lower. Politically, it was more difficult because a lot got a little and a few got a lot. Inevitably, as a result of growing gross income and lower taxes, the propensity to save is rising, which, in the long run, should finance additional investments and facilitate growth.

Nouveaux Riches Versus Nouveaux Pauvres

Under central planning, there were poor and rich people. Determining the lumber of each depends on how they are counted. Whatever method is used, it is undeniable that the market transition has increased inequality and the lumber of people at each end of the spectrum—the poor and the rich. As we hall see, most studies have focused on poverty; we do not know much about he affluent, other than that they exist.

Because of the decline in output and the long-lasting crisis, the extent of poverty in transition countries has increased significantly in the 1990s. As long is the decline in output is linked to inappropriate policies during the transition, growing poverty will be associated with transition. Only a few who were poor prior to the postsocialist revolution have been able to get out of poverty. And, unfortunately, the number of poor is growing. Although circumstances vary among countries, it is possible to group these countries into one of four categories, which range from “very high poverty” (a country where more than half the total population is counted as poor) to “low poverty” (where less than 5 percent is poor)32 (Figure 8.4).

Figure 8.4.Selected Countries: Gini Coefficients in Different Poverty Groups, 1987/88 and 1993/94

(Gini coefficient)

An important issue related to this increase in poverty is the impact of increasing inequality on destitution. Several studies (UNICEF, 1995; Honkkila, 1997; Pomfret and Anderson, 1997; and Milanovic, 1998) show that in some countries (e.g., Bulgaria, Estonia, Poland, Romania, and Uzbekistan), the rise in poverty is more a result of the decline in income equality than of falling income itself. This phenomenon should be considered a very negative byproduct of transition (Table 8.5). Although it has been simply impossible to contain poverty at the time of contraction of GDP—from 20 percent in Poland between mid-1989 and mid-1992 to as much as about 65 percent in Georgia, Moldova, and Tajikistan between 1990 and 1997—there are other significant factors that contribute to the increase in poverty.

Table 8.5.Increase in Poverty and GDP Decline During Transition, 1987–94
Poverty Relative to the Country (21–27 percent of average income)Poverty Relative to the World (Income less than $120 PPP)
1989–901993–94Increase (In percent)1987–881993–94Increase (In percent)1995 GDP Index (1989=100)
Azerbaijan11.165.254.134
Belarus1232254
Bulgaria2.032.730.72333173
Czech Republic0.21.41.20<10–187
Estonia1.027.026.01403966
Hungary1.14.02.9<132–385
Kazakhstan5504546
Kyrgyz Republic12847242
Latvia1.333.532.21252454
Lithuania1.539.137.61464541
Moldova2.440.638.24656140
Poland5.810.95.16191399
Romania7.025.318.36393384
Russia2454354
Slovak Republic0.15.15.00<10–186
Slovenia4.56.11.60<10–193
Turkmenistan12574563
Ukraine2413940
Uzbekistan24472383
Sources: UNICEF (1995). Poverty lines: 21 percent of average income for the Czech Republic and Slovenia; 24 percent of average income for Estonia, Hungary, Latvia, Lithuania, Poland, and the Slovak Republic; and 27 percent of average income for Azerbaijan, Moldova, and Romania (Milanovic, 1998; European Bank for Reconstruction and Development, 1996).
Sources: UNICEF (1995). Poverty lines: 21 percent of average income for the Czech Republic and Slovenia; 24 percent of average income for Estonia, Hungary, Latvia, Lithuania, Poland, and the Slovak Republic; and 27 percent of average income for Azerbaijan, Moldova, and Romania (Milanovic, 1998; European Bank for Reconstruction and Development, 1996).

First, the above-mentioned decline of production ignores the regional aspect of crises. Even when an economy is on the rise, economic decline in the less developed regions may continue, so poverty grows.

Second, transition creates a labor market, so it brings unemployment, which is then worsened by the ongoing recession. The unemployed are provided with modest, if any, benefits. Many remain jobless for a long period and thus become more impoverished (Rutkowski, 1997). The transition countries were unprepared to tackle unemployment, especially a long-lasting one. Whereas in some advanced market economies, such as the United States, less than 5 percent of the unemployed remain jobless for more than one year, in a country like Poland, the figure is over 40 percent.

Third, most of the population, including the retired and those receiving relatively low pensions, have had their savings eroded by rampant inflation and the lack of appropriate indexation mechanisms. In extreme cases—such as Russia’s MMM Investments schemes or Albania’s disastrous, fraudulent pyramid investment schemes—weak and inefficient financial intermediaries as well as political negligence destroy the savings of many households.

Fourth, the ill-advised drive toward illusory fiscal prudence pushes some governments—and, again, Russia’s case is the most spectacular—into postponing the payment of pensions and civil servants’ salaries. The growing arrears, which are merely hidden in the budget deficit and disguised as public debt, reflect the nominal equivalent of unpaid income, which further lowers the standard of living.

Fifth, in the transition countries, the agricultural sector is still quite large. In Poland, which is already an OECD member, as much as 24 percent of the labor force is still engaged in farming. The rapid trade liberalization and inflow of imported food products from more competitive markets have ruined many small farms and left those farmers in poverty.

These five crucial factors led to the emergence of the nouveaux pauvres in the transition economies. In some instances, the nouveaux pauvres are a consequence of the series of unavoidable events; in others, they emerged because of policy mistakes. If conditions could not be better than they were under the centrally planned economy, at least they should not have deteriorated as much as they did. The collapse in output and growing inequality have caused widening poverty, which, in turn, has caused a series of misfortunes: homeless people have appeared on the streets, crime rates have risen, economically motivated emigration has expanded, black markets have mushroomed, life expectancy has fallen (significantly in some countries), and mortality due to social stress has increased (Cornia, 1996b; and Paniccià, 1997).

Life expectancy in Russia and some other former Soviet Union countries (e.g., Latvia and Ukraine) has fallen by several years. Between 1989 and 1995, it dropped for men by a staggering six years. It is claimed (UNICEF, 1995; and Cornia and others, 1996) that, due to this kind of demographic crisis, as many as two million people who were expected to live longer, have died. These authors claim that this excessive mortality has stemmed from the extraordinary hardships imposed by the way transition has been implemented and by the negative accompanying factors, such as crime and violence.33

Poverty has widened in all transition economies, including those leading in both systemic change and growth, because of the time lag between recovery and growth and the improvement of the living standard for society’s poorest. First, real output recovers, then open unemployment grows, and finally the budget allows for increased financing of the social needs of the poorest. Thus, an economy may be on the rise but poverty will not decline for several years.

This sequence of events was seen in Poland, among other countries, where until at least 1995—despite the resurgence of growth that had begun in the second half of 1992—the extent of poverty did not decline. Unemployment rose until the summer of 1994, and salaries in many sectors did not grow until 1995. If the poor are counted as those living below the relative poverty line, defined as the equivalent of half of average monthly household expenditures—then the poor in Poland increased from 12 percent in 1993 to 13.5 percent in 1995, and to 14.0 percent in 1996 (Poland, Central Statistical Office, 1996 and 1997a). Of course, this is a relative measure and does not mean that more people were driven at that time into absolute poverty; in fact, the opposite is true: the portion of the population that benefits from the ongoing economic expansion has been on the rise for a few years. This fact is confirmed by the households’ own evaluation of the standard of living changes. Whereas more than 50 percent of Poland’s households declared their economic position to be “bad” or “very bad” at the time of contraction (early 1990s), this figure fell to 32.5 percent in 1995 and to 30.3 percent in 1997 (Poland, Central Statistical Office, 1997b).

Although it is true that the phenomenon of growing poverty has ended, it is also true that poverty still presents a tremendous challenge for the future. The next few years will determine what income distribution pattern will prevail in the transition economies. And not all countries will follow the same distribution model. It will not be that easy to correct all the mistakes that have been made thus far; it will be extremely difficult—maybe impossible—to reduce inequality significantly in the coming years.

Transition has created a class of nouveaux riches as well. Most are well-educated, hard-working people, who are capable not only of taking care of their own wealth but of doing so by establishing new opportunities for other citizens to improve their standards of living. Of course, in all these countries, as elsewhere, one also finds—again, because of weak institutional arrangements and market experience—thieves, swindlers, and crooks; these and other pathologies must be combated. However, in most transition countries, the majority of the nouveaux riches are members of the new entrepreneurial class.

Some distribution mechanisms help the rich first and only later help the rest of society. After a crisis and the following recession, it takes far longer for the real economy to recover output and profits than for the financial markets to soar. Thus, the living standard of the poor, lowered by the contraction, tends to stagnate longer than that of the rich.34 In extreme cases, while the real economy continued to shrink and therefore the poor became poorer, the financial markets were flourishing; therefore, at least some of the nouveaux riches became even richer.

Every market economy has its entrepreneurial class. They are keen to risk their income in the new ventures on which overall expansion depends. However, how a society distributes its income and wealth depends on historical processes and current policies, which have caused a much more unequal distribution in Latin American countries than in Southeast Asian countries. The way the postsocialist transformation has been managed so far and how it will deal with income distribution in the future will determine the distribution pattern. Already some of the transition countries remind us of Latin American and others of Southeast Asian countries. Despite these similarities, transition economies create their own patterns.

Conclusions

Thus far, transition has brought mixed results. Although inequality has increased in all transition countries—from Albania to Estonia and from the Czech Republic to Mongolia—in some, it has doubled (e.g., in Russia and Ukraine); in others, it has grown by only a couple of points (e.g., Poland and Slovenia); and in yet others, it has stabilized.

Nonetheless, not all income distribution indicators are moving in the same direction. Inequality can be measured by different methods, often with conflicting results. For instance, in Poland between 1994 and 1995, the Gini coefficient (in terms of wages) increased from 28.1 to 28.8; however, the decile ratio for wages was virtually unchanged, hovering around 3.4. This difference is significant, as people usually pay more attention to the latter, that is, to the ratio of rich to poor and how it has changed.

The biggest challenge for policymakers is how to deal with growing inequality and widening poverty. This challenge is made more difficult by the interrelationship between the two as well as a severe, long-lasting recession. Hence, growing inequality is not only a political issue that will provoke tensions and conflicts, but one that creates an economic obstacle to durable growth.

One should not confuse the means and the ends of economic policy (Stiglitz, 1998). Income distribution and a socially acceptable distribution of wealth are just some of the important long-term policy targets. From this perspective, the goal of transition is not only systemic change, but, more important, greater efficiency, increased competitiveness, faster growth, and more sustainable development. Thus, transition is expected to improve the standard of living for all, or at least for the overwhelming majority. Otherwise, the exercise would not make much sense.

Considering the equity and equality issues in policymaking, one has to have a vision, not a delusion. Although inequality typically rises during transition, changes in inequity should be controlled and managed by sound policies. The scope and the pace of these changes cannot be left entirely to the just-released market forces.

In the real world, accomplishing these tasks and getting political support for the implementation of necessary measures is quite difficult. Politics and policymaking are nothing more than the ability to tackle, time and again, conflicts of interest. This is especially true during a transition, when the policies must lead the shift from stabilization to growth and consolidate the stabilization process into lasting stability.

When policymakers trying to catch up with a more advanced world face a trade-off between faster growth with higher inequality (but less poverty) and slower growth with lower inequality (but widening poverty), they can be happy because their choice is clear. Policy should facilitate sustainable development, and income policy should support that goal. Then, in the long run, everyone’s standard of living may improve. After the initial surge of inequality and once the economy begins to strengthen, it may even be possible to reduce inequality without harming growth. This seems to be even more true for inequity. Therefore, the more advanced the transition and the stronger the foundations for fast and durable growth, the weaker the trade-off between equity and efficiency.

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1For instance, in Poland in 1989, about 20 percent of GDP was from the private sector, of which about one-third was nonagricultural.
2The results of recent elections in some transition countries (e.g., in March 1998, in Armenia and Ukraine) support this observation.
3These five countries (the Czech Republic, Estonia, Hungary, Poland, and Slovenia) have been EU associate members since 1994. Five other countries (Bulgaria, Latvia, Lithuania, the Slovak Republic, and Romania) are associated with the EU but have not yet been invited to begin accession negotiations.
4According to EU Commission and Eurostat estimates, the GDP per capita on a purchasing power parity (PPP) basis is ECU 3,900 in Estonia, 5,300 in Poland, 6,300 in Hungary, 9,100 in the Czech Republic, and 10,100 in Slovenia. Thus, their average income is between 35 percent and 65 percent of the average income in Western Europe. This is indeed a very large gap.
5Paradoxically, Russia has, in relative terms, more stock owners than the United States, Poland has more than Germany, and the Czech Republic more than Austria, but that does not mean these countries also have more capitalism. In Poland, a special program of so-called mass privatization—together with many denationalization measures—was implemented. Over 500 state companies, with a total book value of about 10 percent of total state assets pending privatization, were transferred to the population by 15 specially established national investment funds (NFIs) for a nominal fee (equivalent of US$7, or 2 percent of the average monthly salary at the time). As many as 97 percent of eligible citizens participated in the program. Among the remaining 3 percent were, among others, the president of Poland and the first deputy premier and finance minister, who did not collect their certificates because of lack of time. After trading at the secondary market, it is estimated that, at most, one-third of participating citizens retained their acquired shares, whereas two-thirds sold their certificates to other entities for prices five to seven times higher than at the primary market. Most shares so distributed were acquired by institutional investors, including banks and other financial intermediaries.
6In terms of long-run public interest, it is important to reduce public assets and public debt simultaneously. It is unwise to give away assets through any type of free distribution without reducing the public debt stock—domestic and foreign—by a similar amount. Therefore, debt-to-equity swaps should have been used more widely in transition countries. Again, the main obstacle was political. Under the Strategy for Poland program, the ratio of public debt to GDP fell from about 86 percent in 1993 to less than 50 percent in 1997.
7In Poland, the most difficult problem stemmed from claims made by the industrial center (coal mines and steel mills) in Upper Silesia. Regional claims for a national income redistribution were addressed in the program, A Contract for Silesia, adopted in 1995. Fortunately, the program focused not on more favorable transfers but on enhancing local activities and entrepreneurship, raising investment potential, increasing the ability to absorb foreign direct investment, and better coordinating regional development policy. As a result, tensions have eased.
8For the advanced market economies, the scope of the shadow economy is estimated at about 15 percent of GDP for EU countries and below 10 percent for the United States. For Poland, estimates differ: although Herer and Sadowski (1996) believe that it stands at about 25 percent of the official GDP, the author estimates that it is more in the range of 15–20 percent of GDP. What it is in the other postsocialist countries is anyone’s guess. As reported by Agence France Presse (April 12, 1998): “Russian tax police First Deputy Director Vasily Volkovsky told Nezavisimaya Gazeta that one-third of Russian businesses are not paying any taxes, and a further 50 percent pay tax only occasionally. Volkovsky said in the next few years the authorities intended to aggressively scale down the gray economy to a level at which it ceased to pose a threat to Russia’s economic security. He said the gray economy accounted for 45 percent of GDP in 1996” (emphasis added).
9There is a long way to go in countries still at the early stage of transition, such as Turkmenistan. In the most extreme case, Belarus, shortages reappeared in the spring of 1998 because of the government’s attempts to control prices and increase the scope of subsidies. By no means will these price controls be sustainable, however, considering the overall state of the economy and, especially, the fiscal position of the government.
10Dealing with the aftermath of the severe depreciation of accumulated savings is still on the policy agenda in some countries, for example, in Lithuania.
11In some countries—such as Romania and the former Czechoslovakia, which initiated market reforms at the onset of the 1990s—economic reforms have caused more fundamental changes in the labor market. In others—such as Hungary and Poland, which started reforms much earlier—this wage deregulation was only (yet significantly) accelerated.
12Although during the socialist era it was accepted that the state-determined wage ratio between unskilled workers and university professors should not exceed 1:5; during the transition—if the market so determines—this ratio can be as high as 1:15.
13That is fine if the assets are sold at market-clearing prices, but often they are not. And, if not, who is eligible to acquire the assets pending denationalization? When the author, in 1993, asked the then deputy minister of finance in charge of privatizing Poland’s financial institutions why they were selling the shares of Bank Slaski at a fraction of the market-clearing price, he was told that the reason was simple: to provide the new owners with enough capital gains to acquire the next bank. And they were so provided. Two months later on the floor of Warsaw’s stock exchange, Bank Slaski shares were traded at more than 13 times the price asked by the ministry of finance on the primary market! The budget had lost a lot, but a few had gained a lot as well. And the minister of finance was fired.
14The point is that assets distributed on the primary market—for free or for a nominal, symbolic fee—are sooner or later redistributed on the secondary market. Again, people are free to do so, but in the end it leads to the accumulation of these assets by only a few.
15Juha Honkkila (1997, p. 6) rightly claims that “for individuals brought up in a communist society, the loss of safe employment or other social benefits provided by the state sector cannot be offset by minor opportunities to enjoy the personal ownership of assets.”
16For different views on this subject see, among others, Bruno (1992); Kornai (1993); Lavigne (1995); Gomulka (1996); Blanchard (1997); and Kolodko and Nuti (1997).
17According to IMF estimates, in 1997, GDP for the whole region increased by a modest 1.7 percent, and should grow by 2.9 percent in 1998. This year, for the first time since the transition began, none of these countries were expected to undergo a decline in output. The overall expansion was expected to increase further in the medium term (IMF, 1998). This prediction was revised again in the aftermath of the Russian crisis. It is worth noting that in the past, the IMF, in its twice-yearly World Economic Outlook, has wrongly predicted a turnaround.
18Between mid-1989 and mid-1992, the GDP in Poland contracted by about 20 percent and the industrial output by more than 40 percent. In Ukraine, during the nine years (1990–98), the official GDP decreased by more than 60 percent, which is much more than in any other country during peacetime.
19In 1991, an advisor to the Polish government was asked to name the greatest achievement of the stabilization program. His answer was that kiwis can be bought on Warsaw’s streets. In 1997, another advisor said that Russia already has a market economy (which, of course, is supposed to serve society better than the previous system), but people do not yet understand it. The problem is that a market economy must also have sound institutional arrangements, a market culture, and appropriate behavior by people. Thus, as long as people do not understand what a market economy is, they do not have a market economy.
20Data from the HBS provided by the Central Statistical Office (see Poland, Central Statistical Office, 1997a, p. 6).
21In 1997, the then first deputy prime minister, Boris Nemtsov, during his first days in office, made a point that Russia must choose between “bandit-capitalism” and “capitalism with a human face.” President of the European Bank for Reconstruction and Development Jacques de Larosière claimed at the EBRD 1997 annual meeting that in Russia and other former Soviet Union states, in 1996 alone, the outflow of capital from the region probably exceeded the total invested by the EBRD since its creation. Most of this outflow is believed to be linked to illegal economic activities, organized crime, and money laundering.
22Of course, this hypothesis should be carefully reexamined when more data on income dispersion for 1996–98 becomes available.
23Some claim that too great an income inequality acts against growth (Alesina and Perotti, 1996; and Alesina, 1997). Transition economies are no exception in this respect.
24It has to be stressed that in the Polish success story, the acceleration of growth in 1994–97 was mainly due to the gradual privatization, the fast-growing new private sector, and the commercialization of state enterprises (OECD, 1996; Poznanski, 1996; and Kolodko and Nuti, 1997).
25Nevertheless, the comprehensive social security system reform was prepared and launched within the framework of the Strategy for Poland, but not until 1997.
26A relatively high dependency ratio is common to all transition economies. In Poland, due to another miscalculation of the early stabilization policy, many older people were given early retirement. Hence, at the onset of the transition (1990–91), the size of the retired population grew significantly, despite the natural demographic tendencies that would suggest otherwise. Since that period, the average retirement age has fallen to as low as 59 years for men and 55 years for women.
27This is more the result of the assets accumulated in a lifetime than the effect of the current income flow.
28In Poland, dividends are taxed, but at the relatively low rate of 20 percent, which matches the lowest personal income tax bracket; the corporate income tax rate is currently 34 percent and will be reduced to 32 percent in 2000.
29At the beginning of 1994, the personal income tax was raised from 20, 30, and 40 percent to 21, 33, and 45 percent, respectively.
30The author, who was at that time first deputy premier and finance minister of Poland, liked to say, “I don’t need any more opposition—I have enough from my own coalition.”
31About 91 percent of the population are in the lowest bracket. About 7 percent of taxpayers are in the middle bracket, and only 2 percent in the highest.
32Regarding the poverty classification for the transition countries, see Milanovic (1995). The poverty group consists of those with an annual income of less than US$120 (on a PPP basis). Regarding the concept of poverty in China and Vietnam, see United Nations Development Programme (1994).
33In Russia, in 1996, deaths exceeded live births by 60 percent, due to the deterioration of the health standards. This deterioration was caused by poor diet, the breakdown of water-quality control, the worsening of workplace safety, and the growing mortality due to violence, suicide, cardiovascular diseases, and stress. The maternal mortality continues to be 5–10 times higher in Russia than in Western Europe, and infant mortality 2–4 times higher. Deaths from tuberculosis in 1992–96 rose by as much as 90 percent.
34Vice President of the World Bank Mark Malloch Brown, in addressing this issue vis-à-vis the recent East Asian crisis, stressed that “although imbalance in distribution of income declined with growth, the pace of correcting this disparity has slowed down…. Government-driven growth policies have focused on export industries, and no sufficient commitment was made for improving living standards,” as quoted in Development News—Daily Summary, World Bank, Washington, D.C., March 12, 1998, after Asahi Shimbun, March 11, 1998, p. 12.

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