How not to model transition economies

In the nineties, Eastern European economies went through a profound and painful transformation. There were hit by two major shocks: A change in the price system from administered prices to market price, and an opening of the economies to competition from abroad. The first impact of these shocks were very significant drops in the wages and in all manufacturing indicators. As mentioned, these changes were painful, and one could ask whether something could have been done to help ease this transition, for example with foreign aid. It is difficult to imagine where this question could matter in the future (North Korea?), but anyway.

Mohsen Fardmanesh and Li Tan ask this question. They build a two-sector three-factor small open economy model with some particular features: capital never depreciates, trade is fully open, and firms maximize profits. To make model resemble in some way the pre-transition situation, they add a constant to the market clearing condition for non-traded goods to represent shortages. Removing this constant is supposed to represent the change that happened. Then the economy is a new state, and they analyze the impact foreign aid would have had.

This is completely silly. The object of study here is the transition from a steady state to another one. To do this properly, you need to model properly the dynamics. In this case this means: 1) model properly the command economy, showing the allocation of factors across sectors, and in particular modeling technology vintages; 2) model properly the market economy the model is converging to; 3) using the initial factor allocation, show how the economy evolves on the path to the new steady state (it is not instantaneous...) as factor need to be reallocated and in particular become obsolete as the economy is exposed to foreign competition; 4) it helps to model a labor market in order to say anything about wages; 5) introduce households so that anything could be said about the welfare impact of foreign aid, which is the research question after all.

Strategic tax auditing

There is a well published on tax competition between authorities, where the object of competition are tax rates and occasionally public services. But there is another neglected aspect: competition on the thoroughness of tax auditing. This is relevant in countries where local authorities are also in charge of collecting the taxes of the central government.

Alexander Libman and Lars Feld consider the case of modern Russia and find that indeed the willingness to audit depends on the strength of the Moscow. This has two channels: the first is about where audit revenues are directed and whether audit happen in the first place. If there were no audit variations, the share of revenue going to the local government should not vary across regions. Yet, Libman and Feld find that there are systematic variations that can be explained by the power structure, in particular during the loose administration of Boris Yeltsin.

How well does the flat tax work?

The debate about introducing a flat tax regularly flares up, but rarely is it based on a serious case study. The problem is that this debate is overly politicized and camps are formed on ideological lines, not an actual evaluation of the flat tax. Yet, there is data out there, as a flat tax has been introduced in Russia in 2001 and subsequently in six other Eastern European countries.

The flat tax in Russia was quite revolutionary. It is set at 13%, and replaced a system with marginal rates of 13%, 21% and 31%. So just looking at this, tax revenue has to decrease, yet it increased massively. This is not due to a Laffer curve, but rather to a drastic reduction in tax evasion, argue Yurly Gorodnichenko, Jorge Martines-Vazquez and Klara Sabirianova. Using micro data, they find that by measuring in a micro dataset tax evasion by the gap between reported income and expenses. They attribute most of the gain in tax revenue to changes in tax compliance, not to increases in economic activity. Russia's GDP grew by 5% in 2001, nothing unusual for the period.

What does this mean for a flat tax in OECD countries? First, the efficiency gains of such a reform do not seem to be that important. Second, tax compliance is already relatively high, for example in the US, which makes the gains less important in this respect. In the case of the US, a flat tax has, however, still the merit of simplifying an incredibly complex tax system that is the bread and butter of too many accountants.