WHAT EASTERN EUROPEAN TIGERS CAN TEACH WESTERN EUROPE

In yesterday's edition of WSJ, Johnny Munkhammar and Nima Sanandaji wrote a well-argued dissussion (link) on how Eastern Europe's advantage in terms of competitive tax rates, low tax burden and sizeable reform efforts in emerging from the crisis offer a great lesson for economic recovery of the Western counterparts.

RUSSIA'S ROAD TO ECONOMIC RECOVERY

Russia's recessionary contraction has been marked with several distinct features. First, capital account deteriorated significantly. In Q3:2009 it posted a $23.7 billion deficit, reflecting net capital outflows as a result of recovery uncertainties, exchange rate and oil price volatility and the inability of the Russian banking sector of debt repayment. Thus, net capital flows to the private sector decreased by 31.5 percent in Q3:2009.

During the economic crisis of 2008/2009, Russian fiscal policymakers increased government spending when the output gap was positive. Thus, from the mid-2008 onward, Russia faced high inflation rate which peaked well over 10 percent level. Even the fiscal outlook remains sluggish. In 2009, the non-oil government deficit is expected to reach between 11.0 and 12.5 percent of the GDP. The dynamics government deficit remains deteriorating until 2012. In 2010, the non-oil balance is expected at -14.20 percent of the GDP. In 2012, the balance is likely to improve by 1.40 percentage points from 2011. The decline of oil demand has rapidly eroded Russia's reserve fund earnings which decreased from 10.3 percent of the GDP in 2008 to 4.1 percent in 2009. Before the financial crisis, Russia's economic growth model was based mainly on fiscal policy reforms, confluence of high oil prices and access to external financing at low benchmark interest rates. The World Bank estimated that Russia's real GDP will return to pre-crisis level in late 2012. In the long term, Russia's growth quality will be improved only by more dynamic diversification of the economic basis, bold structural, governance and institutional reforms, trade openness, higher productivity growth and liberalized financial sector.

Russia's Macroeconomic Outlook
Source: Central Bank of Russia, Ministry of Finance, Bloomber
*denotes preliminary estimates

Economic Growth in Russia, Central and Eastern Europe and Advanced Economies


Source: IMF, World Economic Outlook, October 2009

SLOVAKIA ADOPTS EURO

On January 1, 2009, Slovakia left ERM II and became the 16th country of the eurozone (here and here). While fiscal consolidation has been sustained through capped deficit spending, inflationary pressures have been normalized due to substantial currency appreciation which also capped import prices. Reviewing data and macroeconomic forecast (here, here and here), output growth is expected to outperform the average of the Euroarea. Until 2013, output is expected to grow at an annual 5 percent rate. Robust output growth is partly due to continuing real convergence in output per capita and partly as a result of koruna appreciation and inflow of foreign direct investment. However, it will be interesting to observe inflationary pressures over the medium term. It is also essential for policymakers to capture fiscal surplus and set medium-term public spending cap. Nonetheless, competitive labor market is required to soften the inflationary pressures which could deteriorate in case of expansionary monetary policy while output gap is expected to close until 2010 despite robust short-term fluctuations.

FLAT TAX IN BELARUS

Belarus is another Eastern European economy joining the flat tax club. The Ministry of Finance has proposed the shift from progressive tax system (with 35 percent top tax rate) to 12 percent flat tax rate. Recently, Financial Times discussed (link) the state of Belarussian economy, focusing essentially on liberalization prospects, tax reform and regulatory reform. According to WB's Doing Business, Belarus's business climate is more favorable after liberalization efforts were endorsed (link).

TAX CUTS IN EUROPE

Forbes reports (link) that Hungarian Prime Minister announced the abolition of 4 percent solidarity tax, a unique layer of tax on company profits that used to finance government's welfare expenditures. In addition, the government announced a decrease in corporate tax rate from 18 percent to 16 percent and payroll tax rate by 10 percentage points. However, after Slovenia and Croatia, Hungary is among the last remaining economies in Central-Eastern Europe without flat-rated income tax (link) that would boost economic growth, investment and job creation. Surprisingly, Greece introduced a gradual reduction in corporate and individual income tax by 5 percentage points over the next five years (link).

RUSSIA'S ECONOMIC NATIONALISM

Financial Times reports that Russia's outgoing president Mr. Putin has signed an act which defined 42 sectors of the economy in which state control of the economy is expanded and foreign investment roughly restricted. Under new law, foreign-owned companies will have to seek government permission in case they want to stake more than 25 percent of the company share in the sectors where free investment and ownership participation is staunchly restricted.

HUNGARY'S FREE-FLOATING EXCHANGE RATE

Earlier, I posted an article about Hungary's low-growth epidemics emerged from a misguided economic policy. Hungary, known for a staggering public finance, recently abandoned currency trading by letting forint float freely (link)

Hungary's macroeconomic attributes are certainly not an admiration. Excessive public spending and prolonged government borrowing to squeeze budget deficit has let the interest rate unsurprisingly high and discounted investment confidence, letting growth prospects to new record lows. Abandoning the regime of targeting exchange rate and the inflation rate has its wise attributes. It makes no sense to manipulate with the exchange rate that could foster currency depreciation at the expense of higher inflation.

Hungary's prospects to join the ERM-2 trading mechanism were railed out after the combination of high government spending and excessive borrowing left one of the major economies in Central Europe out of the euro-zone. The decision to let the forint float freely is not enough. On one hand, Hungary should enhence pro-growth economic and tax policy and its central bank should launch a clear commitment to prudent monetary policy that would keep the inflation frontier at a low level and prevent extraordinary market intervention of the Hungary's central bank.

LAFFER CURVE IN MONTENEGRO

Last year, Montenegro's parliament adopted a 15 percent flat tax on personal income. Tax rate on corporate profits was set at 9 percent and by 2010 Montenegro will have a 9 percent flat tax rate on corporate and individual income (link).

As a result of an expanded tax base and lower tax rate on productive behavior, Montenegro's Tax Administration has collected 36 percent more from annual taxes than in 2006 (here and here).

CROATIA'S EXPOSURE TO MACROECONOMIC CRISIS

In recent years, external indebtedness of Croatia has grown at the fastest pace in Europe. Croatia is, after Lebanon, the country most dependent on foreign loans. The business environment in Croatia has regionally low economic growth rates, high tax burden and inefficient administrative framework such as widespread corruption, weak property rights and extensive market regulation. The paper released by the IMF has shown how banking risks rise in Eastern Europe's case of rapid credit growth (link). On average, Croatia's economic growth between 2002 and 2006 was below 5 percent. In addition, external debt has reached 89 percent of the GDP. High government spending, exceeding 50 percent of the GDP and non-prudent fiscal policy contributed to structural risk of Croatia's economy. While expenditures and consumption-inflated indebtedness have been growing steadily, total factor productivity grew slightly by 1,2 percent. On the other hand, short-term debt increased by nearly 70 percent, from slightly below 4 percent of the GDP to way above 10 percent of the GDP. In a paper issued by the IMF, it is shown that external foreign debt liabilities of Croatia's banks are growing exponentially since 2004.

In such a turbulent picture, there is a significant amount of macroeconomic risk. In addition, there's an extensive availibility of literature and reading on the probability of macroeconomic crisis in Croatia. I suggest the website browsing of the Adriatic Institute, and a paper released by the IMF "Vunerabilities in Emerging South-Eastern Europe - How much Cause for Concern?". There're also few nice articles describing Croatia's macroeconomic prospects (here, here and here). Also, there is an article about Croatia in Washington Times (link).

FLAT TAX EXPANDS INTO GEORGIA

Alvin Rabushka of the Hoover Institution briefly outlines the adoption of the flat tax in Georgia as well as the implications of the tax reform on growth and revenue. Here is some remarkable data: by January 2005 Georgia adopted 12 percent flat tax, replacing previously imposed four-bracket system. The tax reform lower the rate of taxation on productive behavior which, in turn, had dramatic effects on economic growth, averaging 10 percent in the past three years. Tax revenue increased from 14.5 percent of gross domestic product in 2003 to 22 percent in 2006, and should reach 24 percent in 2007.