The economic downturn has had varied impacts across Central and Southeast Europe. A key one, though, has been changes in fiscal and tax policy aimed at increasing the effectiveness of tax collection.

By Piotr Cizkowicz, PhD, Ernst & Young, Economic Strategy Team

The countries of the Central and Southeast European region today face a number of fiscal policy challenges.

A common concern in most countries is the need for additional public sector financing, due to high deficit levels and rising levels of public debt.

The root cause has been the varying degree of impact resulting from the economic downturn.

For example, the Baltic economies contracted more than 10% in 2009, while Poland experienced a more modest slowdown.

As the crisis has deepened, a rapid increase in public debt and deficits has been witnessed in almost all countries in the region. In many, public sector debt levels were the highest ever recorded, at over 60%.

Although economic performance in the region improved markedly in 2010, compared with 2009, in most countries there was no visible improvement with regards to overall government balances.

Fiscal deficits remained high and have been followed by a further increase in public debt.

Was tax regulation a catalyst of the crisis?

Some aspects of tax systems are designed to promote certain types of behavior among both corporations and individuals.

As a result, it is possible that certain regulations added to existing financial pressures on companies and households, with the result that they actually contributed to the economic slowdown.

For example, mortgage interest rate deductions without a corresponding increase in tax from capital gains, favorable tax treatment of stock option schemes over other types of remuneration, and deductibility of interest payments on debt against corporate income taxes may all have collectively resulted in a decline in tax receipts.

By contrast, tax systems can also help to cushion the impact of an economic downturn through automatic stabilizers, such as the use of progressive taxes.

Fiscal policy challenges

In 2010, the total financing needs (the sum of both government deficits and the stock of maturing debt) in most countries in the region exceeded 10% of GDP, which is high compared with historical levels.

However, the situation in most of these countries is more favorable than in advanced economies, where financing needs on average were 25% of GDP in 2010.

In Japan, for example, GDP was 3.5 times higher in relative terms, while its financing needs were about 15 times higher than in the new EU Member States.

Public debt is expected to increase further in most CSE countries until 2015 (see graph above). However, the scale of this increase differs across the region.

The highest public debts are expected to be in Greece, Hungary and Poland, while Estonia should perform better than the rest of the region.

There is a growing risk of sovereign default in several developed countries in the region, which is clearly mirrored in their unsustainable levels of public debt.

Government bond yields in some countries are now much higher than in emerging markets. Furthermore, in the longer term, other factors such as societal aging will put additional pressures on public finance in both advanced and emerging economies.

The CSE’s gloomy long-term outlook

Despite the fact that both economic conditions and fiscal balances are expected to improve by the end of 2011, with fiscal adjustments taking place in most CSE countries, it will not be enough to reduce public debt.

As such, the long-term outlook for public finances is gloomy. According to the International Monetary Fund (IMF), a substantial reduction of fiscal deficits will still be needed to stabilize public debt in most countries, especially when age-related spending is accounted for.

As a result, sharp fiscal tightening is expected in most countries in the coming years, with tax likely to be in the spotlight.

New taxes and tax reforms on the horizon

The financial crisis triggered a debate over several tax reforms that may help to improve financial stability and economic performance. An increase in tax revenues is sorely needed, since a reduction in public expenditure alone will most likely not suffice in many countries.

According to OECD and IMF experts, the majority of additional tax revenue will not be attained through tax rate increases. Rather, broadening the tax base, closing tax loopholes, cutting tax expenditures and introducing climate taxes are all measures that may help to increase tax revenues.

One specific area being discussed in many countries is an additional taxation of banks to cover the potential costs of bailouts. There are also plans for additional taxes on capital transactions, especially foreign portfolio investment.

Both the OECD and the IMF have suggested that the tax burden should be shifted away from taxes on income and toward those on consumption and property.

In short, the new tax landscape will not be easy to navigate, and will be rife with pitfalls for the unsuspecting. Understanding and monitoring these shifts in tax policy, along with the potential financial impact on both companies and employees, is a critical need for any firm operating in the region.

This article was first published in the Ernst & Young Regional Tax Forum 2011 Special edition publication which can be accessed using the link below:

• 3rd Regional Tax Forum 2011, Central and Southeast Europe, Special edition (pdf, 2.08 MB)