Escaping the Under-Reform Trap Author(s): Anders Åslund, Peter Boone and Simon Johnson Source: IMF Staff Papers, Vol. 48, Transition Economies: How Much Progress? (2001), pp. 88-108 Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund Stable URL: http://www.jstor.org/stable/4621691 Accessed: 24-11-2015 21:24 UTC

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IMFStaffPapers Vol.48, SpecialIssue Fund Monetary ? 2001 International

Trap Escaping the Under-Reform PETER ANDERS ASLUND, BOONE,and SIMONJOHNSON* Most former Soviet republics have fallen into an economic and political underreform trap. An intrusive state imposes high tax rates and drives entrepreneurs into the unofficialeconomy,whichfurther aggravates thepressureon official businessmen. Tax revenuesand public goods dwindle,further reducing incentives to register business activity. This economic under-reformtrap has a political counterpart. Remarkably,Communistparties remainpopular and opposed to establishing the rule of law precisely in thoseplaces where theywere able to delay and derail reform.No electoral backlashpromptsthe reformsnecessary to leave the under-reformtrap. The best way out of the trap in countries such as Russia and Ukraine is increased economic and political competitionamong the elite. [JEL E65, H41, K42, P52]

of East-CentralEuropeand most of the formerSoviet Union have fallen

Parts into an economic and political under-reformtrap.Managershide their firms'

activities undergroundin order to escape regulation and reduce the bribes they have to pay. High levels of undergroundactivity keep tax revenues low, which means the governmentcannot afford to provide public goods, such as law and order,thus furtherlowering the incentives for entrepreneursto enter the official economy. These economies are caught in a trap:as few pay taxes, the tax burden upon those who do becomes unbearable,inducing entrepreneursto stay undergroundeven thoughthis keeps theireconomic efficiency low and preventsgrowth. *AndersAslundis SeniorAssociateat the CarnegieEndowment for International Peace in in Moscow,Russia. D.C.PeterBooneis Director of Research UBSWarburg at Brunswick Washington, intheSloanSchoolof Management SimonJohnson is Associate Professor atMIT.SimonJohnson thanks research for theMITEntrepreneurship Centerforsupport. Victoria Levinhaskindlyprovided assistance this article.

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THEUNDER-REFORM TRAP ESCAPING At the same time, senior officials and powerful private individuals live well throughcorruptdeals and sharingrents. This economic under-reformtrap has also an importantpolitical dimension. Remarkably,there is little evidence of an electoral backlash against the people who led countries into the under-reformtrap. Countriesthat have not had much reform tend to have little governmentalchange, quite strong Communistparties, and little impetus for more reform.Conversely,however,countriesthat manageto reformfind that the political supportfor reformsubsequentlystrengthens. Until recently,these problemswere perceived as temporarymattersof transition, but it is now clear that many former Soviet bloc countries have become trapped in a rent-seeking equilibrium. Slow and ineffectual reform created the opportunityfor corrupt bureaucratsand politicians to become entrenched and extract bribes from firms. High inflation offered huge temporaryrents, and the longer it lasted the richer the rent seekers became. Slow privatizationfacilitated extortion by government officials. By the end of 2000 it was possible for an economy to be stabilized,widely privatized,and liberalized,yet remaintrappedby corruption and a large undergroundeconomy. Most former Soviet republics appeartrappedin this way. Can a countrybreakout once it is deeply in the trap?In this paper,the possibilities for two countries-Ukraine and Russia-are compared, and a two-part solution is offered. Economically,rents need to dwindle throughcompetitionand new entry, while political power needs to be dissipated as a consequence of competitionamong the elite. The policy goal should be to foster such competition. It seems more difficult for Ukraine than for Russia to escape from the trap, but even Ukrainehas some reason to hope. This paper updates findings first presented in Aslund, Boone, and Johnson (1996). The economics of the under-reformtrap were studied in Johnson, Kaufmann,and Shleifer (1997). Here we explain the politics of the trap, both in terms of electoral outcomes and the patternof competitionamong the elite.

Trap I.The Economic Under-Reform Post-communist market economies fall into two main groups: those with sustainedrecovery following a relatively radical transformation,and those stuck without sustainedgrowthbecause of gradualreform.In 1999, measuredreal GDP in East-Central Europe was 5 percent lower than in 1989, but in the Commonwealth of Independent States (the former Soviet Union without the Baltics), real GDP was just 56 percentof its 1989 level (ECE, 2000, p. 225). While performancehas divergeddramatically,measuredGDP exaggeratesthe discrepancy,because the unofficial economy has expanded much more in the formerSoviet Union thanin east-centralEurope.Table 1 shows the results of estimating the share of the unofficial economy in total GDP through 1995 using the electricityconsumption-basedmethodologypresentedin Johnson,Kaufmann,and Shleifer (1997). Two divergentdevelopmentpaths are evident. The ratherliberal East-CentralEuropeancountriesstartedwith a relativelylargeunofficialeconomy, which peaked in 1992, and then declined moderately.In contrast,the unofficial

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Table1.Shareof UnofficialEconomy

0 0,

1994

Officia GDP in 1994 1995 (1989= 10

29.9 16.9 28.5 18.5 16.4 16.2

29.1 17.6 27.7 15.2 17.4 14.6

36.2 11.3 29.0 12.6 19.1 5.8

72.3 81.0 83.4 92.0 72.7 77.9

51.2 11.0 24.1 61.0 27.2 31.0 31.7 34.0 36.7 38.0 10.1

58.0 18.9 25.1 63.5 34.1 34.2 28.7 39.7 40.3 45.7 9.5

60.6 19.3 11.8 62.6 34.3 35.3 21.6 35.7 41.6 48.9 6.5

30.1 62.5 67.1 15.6 51.0 48.1 43.9 41.7 51.3 44.2 85.0

Shareof the UnofficialEconomy (percentof totalGDP) 1990 1991 1992 1993

Countries

1989

EasternEurope Bulgaria CzechRepublic Hungary Poland Romania Slovakia

22.8 6.0 27.0 15.7 22.3 6.0

25.1 6.7 28.0 19.6 13.7 7.7

23.9 12.9 32.9 23.5 15.7 15.1

25.0 16.9 30.6 19.7 18.0 17.6

FormerSovietUnion Azerbaijan Belarus Estonia Georgia Kazakhstan Latvia Lithuania Moldova Russia Ukraine Uzbekistan

12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0

21.9 15.4 19.9 24.9 17.0 12.8 11.3 18.1 14.7 16.3 11.4

22.7 16.6 26.2 36.0 19.7 19.0 21.8 27.1 23.5 25.6 7.8

39.2 13.2 25.4 52.3 24.9 34.3 39.2 37.3 32.8 33.6 11.7

Source:Johnson,Kaufmann,andShleifer,1997. Note:We reporthereall EasternEuropeanandformer SovietUnioncountriesfor whichthese dataare available.

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THEUNDER-REFORM TRAP ESCAPING

share in former Soviet countries was initially small and rose sharply until 1994 before flattening out. Strikingly, while the Polish unofficial economy share declined from 1989 to 1995 by 3 percentof GDP, its sharein Russia and Ukraine surged by 30 percent and 37 percent of GDP, respectively. More recent work (through1997) shows the same patternhas continued-the unofficial economy is typically 2-3 times larger,as a percentof GDP, in the formerSoviet Union thanin east-centralEurope (Eilat and Zinnes, 2000). Adjusting for the unofficial economy, the contractionin real GDP has been much lower than commonly supposed. In Russia, for example, output probably fell no more than 20 percent duringtransition,but qualitatively,the large unofficial economy is an essential part of the under-reformtrap. A large unofficial economy means that few pay taxes, inciting governmentsto raise tax rates for those few while providing minimal public goods, thus inducing entrepreneursto opt for the undergroundeconomy in a vicious circle. Conversely, a marked difference has developed especially between Central Europe and CIS countries in terms of general governmentspending as a percent of both official and total GDP. In CentralEurope (Poland, the Czech Republic, Slovakia, and Hungary), general government spending declined insignificantly from 51 percentof GDP in 1989 to 46 percentof GDP in 1999 (Tanzi, 1999). By contrast,general governmentspendingin the CIS fell on averagefrom 46 percent of official GDP in 1992 to 27 percentin 1999 (Tanzi, 1999). The low level of tax collection is no reflectionof liberalismin most CIS countries. While their level of actual tax collection varies greatly, the tax burdenon those who actually pay taxes is much higher than in Central Europe (Johnson, McMillan, and Woodruff,2000b). In fact, either high state revenues or high de facto tax rates have characterizedpost-communistcountries. The functioningof the tax system is a reflectionof a broaderqualitativedifference between these two subregions.A group at the WorldBank originally calculated a composite structural reform index, which mainly reflects external liberalizationandprice liberalizationbut also privatization(De Melo, Denizer,and Gelb, 1997). For an ideal marketeconomy, this index would be 1.00. As early as 1992, centralEuropehad an averagestructuralreformindex of 0.83, while it stood at 0.29 in the CIS. Over time, the CIS countrieshave caught up, but when central Europerecorded0.90 in 1999, the CIS countriesreachedan averageof only 0.63 (see Table 2). Because of slow initial reforms, the CIS countries have become stuck at a lower level of liberalizationand privatization. While East-CentralEurope and the former Soviet Union have converged greatly in stabilization,liberalization,and privatization,this is not true of fairer taxation, fewer regulations,and the rule of law. Countrieswith less distortionary tax and regulatory systems have larger official economies, collect more tax revenues, and provide more public goods. The former Soviet Union is particularlybad at protectingentrepreneursfrom extortion by governmentofficials (Frye and Shleifer, 1997; Shleifer, 1997). The survey reportedin Johnson, McMillan, and Woodruff(2000a) indicates that the effective or perceived tax rates are almost twice as high in Russia and Ukraine compared with three East-CentralEuropean countries (Poland, Slovakia, and 91 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

AndersAslund,PeterBoone,and SimonJohnson

Table 2. StructuralReformIndex, 1990-99 1990

1991

1992

1993 1994

1995

1996 1997 1998 1999

CentralEurope Poland Czech Republic Slovakia Hungary

0.68 0.16 0.16 0.57

0.72 0.79 0.79 0.74

0.82 0.86 0.86 0.78

0.82 0.90 0.83 0.82

0.83 0.88 0.83 0.83

0.79 0.82 0.79 0.82

0.79 0.82 0.79 0.82

0.81 0.82 0.77 0.87

0.86 0.90 0.90 0.93

0.86 0.90 0.90 0.93

SoutheastEurope Romania Bulgaria

0.22 0.19

0.36 0.62

0.45 0.86

0.58 0.66

0.67 0.63

0.65 0.61

0.64 0.57

0.66 0.67

0.76 0.79

0.82 0.79

Baltics Estonia Latvia Lithuania

0.20 0.13 0.13

0.32 0.29 0.33

0.64 0.51 0.55

0.81 0.67 0.78

0.83 0.71 0.79

0.77 0.67 0.71

0.78 0.74 0.74

0.82 0.74 0.74

0.90 0.86 0.82

0.93 0.86 0.82

CIS Russia Belarus Ukraine Moldova Armenia Azerbaijan Georgia Kazakhstan Kyrgyzstan Tajikistan Turkmenistan Uzbekistan

0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04

0.10 0.10 0.10 0.10 0.13 0.04 0.22 0.14 0.04 0.11 0.04 0.04

0.49 0.20 0.23 0.38 0.39 0.25 0.32 0.35 0.33 0.20 0.13 0.26

0.59 0.33 0.13 0.51 0.42 0.31 0.35 0.35 0.60 0.26 0.16 0.30

0.67 0.42 0.33 0.54 0.46 0.33 0.33 0.42 0.71 0.42 0.29 0.50

0.64 0.50 0.54 0.64 0.54 0.40 0.50 0.50 0.71 0.40 0.27 0.57

0.71 0.44 0.57 0.64 0.61 0.44 0.61 0.64 0.67 0.40 0.27 0.57

0.72 0.37 0.59 0.64 0.61 0.51 0.66 0.66 0.70 0.39 0.36 0.54

0.64 0.37 0.65 0.76 0.76 0.61 0.79 0.79 0.82 0.55 0.36 0.57

0.64 0.37 0.65 0.76 0.76 0.61 0.79 0.72 0.79 0.58 0.36 0.50

Sources:De Melo, Denizer,andGelb (1997);HavrylyshynandWolf(1999), p. 34; authors'calculationsfromEBRD (1998), p. 26, andEBRD (1999), p. 24. Notes: This index was originallyestablishedby De Melo, Denizer,and Gelb (1997), with World Bank assessmentsfor 1990-94. They also indicatedhow their assessmentswere relatedto EBRD indices.HavrylyshynandWolf(1999) updatedtheirseriesfor 1995-97, while we haveupdatedcorreThe firstelementis 0.3 timesEBRD's spondinglyfor 1998 and 1999.The formulais straightforward. indicesfor priceliberalizationandcompetitionpolicy.The secondelementis 0.3 timesEBRD'sindex for tradeandforeignexchangeliberalization.The thirdelementis 0.4 timesEBRD'sindicesfor largescale privatization,small-scaleprivatizationandbankingreform.Eachindexis normalizedto reacha maximumof 1. Thus,this indexrepresentsliberalizationto 73 percent,while the rest is privatization. The weights have been arbitrarilyselected, but actuallyit does not mattermuch what weights are chosen for the countriesrelativestandingto one another,as the covarianceis great.

Romania). The evidence suggests that Central Europe, in particular,has made substantialprogress towardsreformingits institutions,while most of the former Soviet Union lags far behind, being caught in an under-reformtrap, with high effective taxationand intrusiveregulation. The most powerful entrepreneursrespond with various forms of "state capture"(Hellman, Jones, and Kaufmann,2000), effectively privatizingpublic goods such as taxationand regulationto theirown benefit, drivingout competitors 92 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

THEUNDER-REFORM TRAP ESCAPING

who are tryingto obey the law. Small entrepreneursexit the official economy, and about half of the economy is now underground.Russia, Ukraine,and most of the CIS have become truerent-seekingsocieties with a suboptimalequilibriumof low economic efficiency (for modeling of such an equilibrium, see Johnson, Kaufmann,and Shleifer, 1997).

II.The Electoral Under-ReformTrap The economic under-reformtraphas a political counterpart.In a democracy, it would be reasonableto presumethat informedcitizens would vote for political parties advocating policies that have brought about economic growth in other countries.In general,among postcommunistcountries,marketreformand democracy are strongly positively related, as Figure 1 shows. Full democracies have usually undertakenadvanced marketreform, while semi-democraticstates have usually pursuedlimited reform, and real dictatorshipshave done little reform, as is specified in Figure 2.

Figure1. Democracyand MarketReform,2000 Turkmenistan •

S

6 -

U

5

Uzbekistan

Tajikistan

Belarus

mKazakistan Azerbaijan KyrgyzRepublic

-

rAlbania

u

Armenia

8

4 ,..Russia 4-

mCroatia II Ukraine

S

N Moldova\EMacedonia o Bulgaria Hungary Romania\ •m

3 •

2 -

0

Poland Lithuania Slovenia 0.1

Georgia

0.2

0.3

0.4

0.5

0.6

0.7

Estonia

? Latvia U

U U

CzechRep.

Slovakia 0.8

0.9

1

WorldBank/EBRDStructuralReformIndex (from 0 = low to 1 = high)

The countriesof particularinterestto us are those that have gotten stuck in an under-reformtrap--those in the middle of Figure 1: Ukraine,Moldova, Bulgaria, Romania,and Russia. These countrieshave underperformedin termsof economic reforms and economic growth (see Tables 1 and 2), and even so, the responsible governmentshave repeatedly survived relatively free elections. How could this have happened? 93 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

AndersAslund,PeterBoone,and SimonJohnson

Figure2. Democracy and MarketReform AdvancedReform Free

Poland Czech Republic Estonia Hungary Latvia Lithuania Slovenia Slovakia Romania Bulgaria

Partialyfree

Croatia Macedonia

Not free

Limited Reform

LimitedMarketReform

Albania Armenia Georgia Moldova Ukraine Kyrgyztan Russia Azerbaijan Kazakhstan

Belarus Tajikistan Turkmenistan Uzbekistan

Note:Countries wereclassifiedby FreedomHouse(2000)as "free""partlyfree,"or"notfree."Theborderreform"and"limitedreform" reformindex linebetween"advanced hasbeenputat0.80on theEBRDstructural for2000,andas borderline between"limitedreform"and"littlemarketreform," theindexvalue0.62 hasbeen chosen(EBRD,2000).

Assessing ElectionResults In order to understandthe politics of under-reform,we scrutinize election results.We review only parliamentaryelection outcomesbecausepresidentialelections tend to be dominatedby personal factors and offer a narrowchoice, while local elections are rarelyrelevantfor nationalpolicy. Only election resultsin countries with a reasonabledegree of political freedom can be considered. Nineteen countries in the postcommunistregion fulfill this criterion, being classified as either free or partly free by Freedom House (Karatnycky,Motyl, and Graybow, 1999, p. 15). Seven countriesdo not qualify as even partlyfree, and they are therefore excluded (Azerbaijan, Belarus, Kazakhstan, Tajikistan, Turkmenistan, Uzbekistan,andYugoslavia).To categorizethe electoral outcomes, we need some kind of partystructure.Hence, Kyrgyzstanis omitted,because it had its first multipartyelections in 2000, and even then partiesplayed only a minorrole. Partystructuresvary much more in postcommunistcountriesthan in Western Europe. For our purpose, electoral outcomes are most easily classified by the Communistpartyand its direct successors.Althoughthe Communistpartieshave been renamedin most countries, one evident successor party usually exists, and splintergroups tend to alter their appearance.

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ESCAPING THEUNDER-REFORM TRAP

Figure3. CommunistPartyElectoralPerformanceand Market End-1999 Economic Transformation, CommunistParties Doing Well

CommunistParties Doing Badly

Radical transformation Hungary Poland

Croatia Czech Republic Estonia Latvia Lithuania Slovakia Slovenia

Incomplete transformation

Armenia Georgia

Bulgaria Macedonia Moldova Romania Russia Ukraine

and"incomplete Note:Theborderline between"radical transformation" transformation" hasbeenputat between"communist 0.80 on thestrtuctural reformindexfor 1998(seeTable2), andas borderline parties partiesdoingbadly"20 percentof the votesin thelastelectionsupto summer doingwell"and"communist 2000hasbeenchosen(seeTable3)

Even Communistpartiesevolve. They can be dividedroughlyinto two groups: those turningSocial Democratic and those remainingCommunistparties (sometimes becoming nationalist).Among the democraticcountries,the old Communist partieshave become Social Democraticin Poland, Hungary,Slovakia, Lithuania, Slovenia, and Macedonia,while they remainhardline in the Czech Republic and throughoutthe formerSoviet Union. This dichotomy remainedlargely true at the end of 2000.

ParliamentaryElectionResults All the democraticor semidemocraticcountriesin the region have undertaken some marketeconomic reforms.If such reformswere truly unpopular,we would expect Communistparties to gain popularityand even win electoral majorities. However,Table 3 shows that Communistparties have fared poorly regardlessof countryand policy, with the exception of the marginalcases of Albania(where the "democratic"forces abandoneddemocracyin 1997) and Mongolia in 2000 (which is disregardedhere as a very special case). By 1997, no other Communistpartyin the region had attainedone-thirdof the votes cast in the most recent democratic election, and the Communistparty was not the senior partnerin any government. The Communistparties in Italy, France, and Finland were actually larger during the Cold War.Apparently,the popular nostalgia for communism has been very limited. Results from all the parliamentaryelections are summarizedin Table 3, and these offer some intriguingconclusions.At the end of 1999, these countriescould

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Electionsin Post-commun VoteSharein Parliamentary Table3. Ex-communist

(2, ,O

Country

FirstElection

VoteShare SecondElection

56.2 March1992 Albania March-April1991 1990 Armenia minority July 1995 47.2 Oct. 1991 June 1990 Bulgaria 26.5 Croatia Aug. 1992 April-May1990 13.6 June 1992 June 19901 CzechRepublic March19902 Estonia Minority Sept. 1992 Oct. 1992 Oct.-Nov. 19902 Tinyminority Georgia 10.9 May 1994 Hungary March-April1990 June 1993 Latvia minority March-April19902 Lithuania Feb.-March19902 minority Oct.-Nov. 1992 Oct. 1994 Nov.-Dec. 1990 25.8 Macedonia Feb. 19902 Moldova Feb. 1994 majority 61.7 June 1992 July-Aug. 1990 Mongolia Oct. 1991 Poland June 19896 minority 66.3 Romania Sept. 1992 May 1990 Dec. 1993 Russia March19902 majority 13.6 June 1992 June 19901 Slovakia 22.7 Dec. 1992 Slovenia April 1990 March1994 March19902 Ukraine majority

VoteShare

ThirdElection

VoteSh

25.6 12.1 33.1 5.4 14.2 13.63 2.7 4 33.0 12.05 42.6 48.3 4 22.0 57.0 12.0 37.9 12.4 15.2 13.6 minority

May 1996 May 1999 Dec. 1994 Oct. 1995 May 1996 March1995 Nov. 1995 May 1998 Sept.-Oct. 1995 Oct.-Nov. 1996 Oct. 1998 March1998 June 1996 Sept. 1993 Nov. 1996 Dec. 1995 Sept.-Oct. 1994 Nov. 1996 March1998

Rigged(20 12.0 43.5 Tiny 10.3 5.9 3.8 32.9 12.95 9.5 25.2 30.1 40.5 20.4 21.5 22.7 13.1 16.1 24.7

ElectionsandDevelopments.23-29 Union (www.ipu.org).Chronicleof Parliamentary Sources:Inter-Parliamentary Cooperationin Europe.Electionsin CentralandEasternEurope.December1990;Factson File WorldNews Digest. Note:Countriesthatwereclassifiedby FreedomHouse(Karatnycky, Motyl,andGrabow,1999)as not freehavebeen Uzbekistan,andYugoslavia.Kyrgyzstanhas not hadany partyelections. Kazakhstan, Tajikistan,Turkmenistan, 'TheJune1990electionresultfor the CzechRepublicwas for all of Czechoslovakia. 2Politicalpartieswere not allowedduringthe 1990 electionsin anyof the countriesof the formerSoviet Unionor in 3InSeptember1992 in Estonia,the partiesSafe Home, OurHome Estonia,and the UnitedPeople'spartyqualifya primarilyRussiannationalparties. 4Forthe October1992 resultin Georgia,andMacedoniain October1994,the numbershownis shareof seats, not v 5Latviahas had a series of Russiannationalistparties(Harmonyfor Latvia,Rebirthof the EconomicUnion, andth been trueCommunistparties,led by the old hard-linecommunistleaders. 6TbeJune 1989 electionin Polandwas only partlyfree. 7InJanuary2000, the Croatianformercommunistswere includedin a broadvictoriouscoalitionparty.

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ESCAPING THEUNDER-REFORM TRAP

be divided into countries where the Communist parties received more than 20 percentof the votes cast in the latest parliamentaryelection (nine countries),and countrieswhere they obtainedless than20 percent(eight countries).The threshold is a naturaldivision with no countryin the intervalof 16-21 percent.The summary classification is displayed in Figure 3, matching this political division by their degree of marketreformin 1998 (with the thresholdset at 0.8), splittingthe democratic transitioncountriesinto four quadrangles. Three typical electoral paths can be distinguished.First, the top left box in Figure 3 contains two countries that have undertakenradical marketization,and even so, their Communistparties are doing well, namely Poland and Hungary. Their communistswere almost routedin 1991 and 1990, respectively.They have staged strong comebacks to about 30 percent of the vote, however, as they were thoroughly reformed early on, becoming right-wing Social Democratic parties. These countries' successful market economic transformationconvinced even communistleadersto reform,securingtheirpolitical survival,and theirconversion led to the formationof a marketeconomic consensus. Second, in nine countriesthe Communistpartiesare now weak, receivingonly 10-16 percent in the latest elections. These countries have all gone through substantialmarketeconomic transformationand achieved substantialand lasting growth. They should all be in the right upper box in Figure 3 (the latecomers, Armenia and Georgia, have almost qualified).All these Communistparties have undergone far-reaching reform, with the exception of the Latvian National Harmony party, but not fast enough to jump onto the market economic bandwagon. A broadconsensus in favor of marketreformwas achieved withoutthem. This does not mean, however,that they are discreditedfor good. In Lithuania,the former communists made a strong comeback in the elections of 2000 as social democrats. The bottom left box in Figure 3 representsthe political under-reformtrap.It contains six countries where Communistpartieshave been relatively successful, while the marketeconomic transformationhas been insufficient.These six countries are Bulgaria, Romania, Macedonia, Moldova, Ukraine, and Russia. Two different patternsare in evidence, depending on whether the Communistparties stayed in power or not. In Bulgariaand Romaniathe formerCommunistparties held on to power in democratic elections until 1996-97. The cause of their demise was rampant economic crises, for which the communistgovernmentswere clearly responsible. In these two countries,the corruptpolicies of partialreformwere discredited,and people voted against their bitter experiences of communist governmentsin the post-communist period. In Bulgaria, a break with the system of rent seeking occurred,while the communistsreturnedto powerin Romaniain 2000, illustrating the tenacity of the under-reformtrap. In Russia, Moldova, and Ukraine, the old Communistparties have remained strong, usually gathering20-30 percent of the votes cast. While not formally in power in Ukraine or Russia,1 the communists have been highly influential in 'Moldovangovernmentshavebeen bothunstableandhardto categorizeprecisely.

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AndersAslund,PeterBoone,and SimonJohnson parliament,as the electoral system made them over-represented,allowing them to block reformlegislation in coalition with otherparties. Whetherin governmentor not, strong Communistparties have ensured that the state has remained all-intrusive, with high taxation and extraordinaryrent seeking. The naturalpolitical outcome has been a state dominatedby powerful oligarchic business groups. The concentratedeconomic power aroundthe state also circumscribeddemocracy,while politics became polarizedbetween oligarchs and communists.Ironically,both groupsfavorsimilareconomic policies and agree on having a rent-seeking state. Accordingly, the EBRD (1999) finds that state captureis the greatestin these semi-reformedcountries(see also Hellman,Jones, and Kaufmann,2000). The communistsremainstrong electorally because of dissatisfactionwith the new semi-reformed system, which produces little growth but great inequality, while noncommunists vote for the strongest organized contenders against the communist threat. With few independententrepreneurs,the liberal right is too weak to counterbalanceboth communistsand oligarchs.Thus communistsremain reasonably strong and unreformedwhen market-orientedeconomic transformation is slow. This is the political under-reformtrap.

Ill.Stickinessof the ReformTrap The countries of greatest interest for our analysis are Russia and Ukraine.2 Both countriesfailed to attainsignificanteconomic growthuntil 2000 because of late and partialreforms.To understandtheir problem,we first examine the initial rents in these societies. Next, we check the ensuing effects on the dominant economic-political groups. Finally, we consider the stability of the situation and how it may change.

EarlyRentsin Russiaand Ukraine A mixture of state enterprisemanagers,new entrepreneurs,governmentofficials, commodity traders, bankers, and outright criminals have grown rich on governmentsubsidies and regulations,that is, rent seeking. Today's rent seeking can be tracedback to four dominantearly forms of rent seeking in both Russia and Ukraine. The first form of rent seeking was to buy commodities on the domestic market,which were cheap because of price regulation,and sell them abroadat the world marketprice. This requiredaccess to the commodities and export permits. About 40 percentof Ukraine'sexportsin 1992 were commodities(mainly metals; IMF, 1993b, p. 113), and their averagedomestic price was about 10 percentof the world marketprice. Hence, the total exportrentsamountedto some $4.1 billion or 20 percentof GDP in 1992. The beneficiarieswere managersof statemetallurgical companies, commodity traders,foreign trade officials, and some politicians. In 2Thissectiondrawson Akslund (1999 and2000).

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Russia, which had more commoditiesto export(mainly oil and metals), the export rents in 1992 amountedto $24 billion or 30 percentof GDP (IMF, 1993a). The second methodwas to importcertaincommodities,notablyfood in Russia and energy in Ukraine, at a low subsidized exchange rate and resell them at a higher domestic price. The main beneficiaries were a small number of gas importersin Ukraineand food importersin Russia. In Russia, the importsubsidies amountedto 17.5 percent of GDP in 1992 (IMF, 1993a), and they were probably as sizable in Ukraine,largely pertainingto energy importsfrom Russia. The third form of rent seeking was access to subsidized credits. In 1993, Ukraine experienced 10,155 percent inflation, but huge state credits were issued at an interestof 20 percenta year--that is, state creditswere sheer gifts, and they were given to a privilegedfew. In 1992, net creditexpansionto enterpriseswas no less than65 percentof GDP and 47 percentof GDP in 1993 (calculatedfrom IMF, 1993b, p. 109; IMF, 1995, pp. 73, 105). In Russia, the net creditissue of the central bank was 31.6 percentof GDP, and it was less in 1993 (IMF, 1993a). Thus, these rents were greaterand more lasting in Ukrainethan in Russia. The fourthform of rents was direct budget subsidies, which amountedto 8.1 percentof GDP in 1992 and 10.8 percentof GDP in 1993 in Ukraine(IMF, 1995, p. 94). In Russia, they were 10.8 percentof GDP in 1992 and 9.4 percentof GDP in 1993. In both countries, these subsidies were concentratedon agricultureand energy-that is, gas in Ukraineand the coal industryin both countries.The subsidized industriesbecame totally criminalizedby a struggleover these subsidies. In total, rents as a shareof GDP were huge in both countriesbut somewhathigherin Ukrainethan in Russia in both 1992 and 1993 because of greatercredit emission in Ukraine (Aslund, 1999, 2000). Much of these rents have been accumulated abroadin tax havens. In this way, a small select groupof privilegedinsidersusurpeda huge shareof GDP in the early years of transition and grew strong. They have no reason to abandontheir enormouspower and wealth, which are based not on property,but on divertedfinancialflows. For society, the result has been sharplyrising income differentials.Ukrainehas reacheda Gini coefficient of 47 and Russia 48, which is about the same as the LatinAmericanaverage(Milanovic, 1998, p. 41). By 1996, macroeconomic stabilizationwas happily taking hold at long last in both countries, as the originalrents dwindled,but the rent seekers stayed rich and powerful, inventingnew rents. Both Russia and Ukrainehave well-developed oligarchic power structuresof so-called financial-industrialgroups,whose essence is to use political influence to extract rents. A good relationship with the presidency has been essential to success. In both cases, control over the media has been helpful to developing a power base. In Ukraine,the oligarchs sit in parliamentthemselves and lead large parties, while Russian oligarchstend to hire parliamentariansand purchasespecific votes. The Russian oligarchs started as small traders.Then they became bankers and commoditytraders,moving on to the productionof raw materialsfor exportin the mid-1990s, and now they are going into manufacturing.The Ukrainianoligarchs remaincommoditytraders,but a few have takento metallurgyand the production 99 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

AndersAslund,PeterBoone,and SimonJohnson of energy (Brady, 1999; Aslund, 2000). The governmentand the leading businessmen live in a curious symbiosis and mutual dependence. In order to be reelected, politicians need the support of the top businessmen (particularlythose who control the media), but the tycoons can be ousted by politicians if they turn against the political leaders. Especially in Ukraine, an iron triangle of government, businessmen, and parliamentruled the countryuntil 1998. All three groups favored a maximum of regulationand state interferenceto maximize rent seeking and corruption,while the effects on the populationas a whole were of little consequence. The government malfunctionedin the interests of the rent-seekingelite. This model of selfreinforcing rent seeking looked like a frightfully stable suboptimalequilibrium, reminiscentof the distributionof power in a stagnantAfricancountry(Collier and Gunning, 1999). Yet, the natureof the oligarchs' interactionwith one anotherand the government changes swiftly. The main institutionalchange occurredwith privatization. Previously,the buddingoligarchs merely colluded with state enterprisemanagers and governmentofficials. Now, they became owners of large enterprises,which were by necessity visible. Their dependenceon the state diminished.They started defending privatepropertyrights, and they representeddifferentindustrialinterests. Their greater security and more clearly defined interests intensified their competition.As a result, their competition was transformedfrom obscure court intrigueto publicpolitics. In Russia, this occurredin 1994, afterthe initial voucher privatization,while in Ukraineit happenedonly in 1998-99, afterthe large metallurgical companieshad been privatizedin obscure inside privatizations. In parallel,the legal situationchanged.At the end of communism,large-scale business was pervasively criminal and the murderrate rose steeply. Government was unableto providethe legal institutionsthatmake contractsenforceable.Crime grew increasinglyorganized,and majorbusinessmenestablishedtheir own security organizations. Greater order reduced the murder rate (Aslund, 1997). In Russia, the internecine murderingamong major businessmen ceased in 1994, while it continueduntil 1996 in Ukraine.In recent years, the police have reestablished their monopoly of violence, but their services are often bought by businessmen (Hellman,Jones, and Kaufman,2000). The demandfor court services is rising steeply,promptinghigherbribesforjudges, while civil servantsare deprived of bribes, since they no longer have much to sell. After most propertyhas been distributedby state officials, the focus of briberymoves to judges responsiblefor the securityor redistributionof property.

Policies for Breakingthe Trap Looking back on the past decade, the fast qualitativechanges are striking,and the stabilityof the suboptimalequilibriummust not be exaggerated.For instance, overindustrializationis soon to become a memory,as value detractionhas faded. From 1989 to 1998, the shareof industryin GDP in Russia andUkrainecontracted by 15 and 14 percent,respectively (WorldBank, 2000). Futureeconomic reform in the former Soviet Union should be seen in this new light. The best option of 100 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

ESCAPING THEUNDER-REFORM TRAP

swift, comprehensive, and radical reform is no longer available, leaving two contraryalternatives,eithercollusion or competition. The advantages of collusion or deal making have been analyzed by some economists and political scientists. Andrei Shleifer and Daniel Treisman (1998 and 2000) and Treisman (1998) have argued that it facilitated privatizationand macroeconomicstabilizationin Russia. This was certainly true for privatization. Ukraine,however,has aboundedwith deal making with no benefit for reform. A competitive approachappears,instead, more likely to reduce rent seeking. In their book, Mercantilismas a Rent-SeekingSociety, Robert B. Ekelund and RobertD. Tollison arguedthat mercantilismended in Britainbecause of a competition between the royal court and the parliamentover monopoly rents and jurisdiction. In a similar vein, Andrei Shleifer and Robert Vishny (1993) have suggested that corruptionshould be fought throughcompetitionratherthanprohibition, which often implies a reinforcementof the monopoly of corruption,characteristic of the Stalinist system. Shleifer and Vishny (1998) and Shleifer and Treisman (2000) have devised methods for how to organize competition among rent seekers to drive bribes and rents down toward zero. When rents dwindle, smartoperatorsmight find productivebusiness more lucrative. Competition is the opposite of a political and economic monopoly, and it involves both politics and economics. A competitive approachto reform can be described as seven related goals: (1) to split the political and business elite into different groups; (2) to form independentpolitical associations and enterprises with secure legal bases; (3) to encourage competition among different groups; (4) to achieve political and economic discontinuity;(5) to diminish the state's strangleholdon economy and society; (6) to achieve a maximumof transparency; and (7) to break up or regulate monopolies. This competition should aim to diminishrent seeking, thus enhancingeconomic efficiency. Thereis a fundamentaldifferencebetween taxationand regulationwith regard to desirablereforms. In taxation, competitionmust be avoided, as it leads to the kind of overgrazingthathas proliferatedin the CIS and in many developingcountries (Shleifer and Treisman, 2000; Johnson, Kaufmann, and Zoido-Lobaton, 1998). In regulation,however,competitioncan minimize bribery. A first goal is to create more independentbodies. Throughoutthe post-Soviet region, rent seeking has prosperedaroundso-called naturalmonopolies in energy and transportation(oil, gas, coal, pipelines, railways, and telecommunications), but many of these are not naturalmonopolies. Telecommunicationshave been divided and successfully turned competitive in Russia. Similarly, Russia has brokenup its oil industryinto a dozen majoroil companies.Although only one of these privatizationswas undertakenthroughcompetitivebidding, the Russian oil industryhas been transformedinto a highly competitiveindustry.The naturalgas monopoly Gazprom,on the contrary,retainsmost ministerialregulatoryfunctions, forming the main bastionof asset strippingby managersthroughbarterand transit pricing, while it is badly mismanaged. Coase's Theorem (Coase, 1988), that the initial distributionof propertydoes not matterbecause propertycan be traded,has been much maligned. It presupposes the absence of transaction costs, which are very high in the transition 101 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

AndersAslund,PeterBoone,and SimonJohnson economies. Consideringhigh transactioncosts, however,it can be modified into a less stringenthypothesis:it is more importantthatprivatizationbe undertakenthan how it is undertaken.Historically,states have lived without privatepropertyfor centuries, while robberbaronstend to be disciplined by the marketwithin a few decades. Over time, more propertylegislation is promulgated,and propertyrights are reinforcedthroughpractice,as reflectedby increasedusage of courtsby enterprises (Hendley and others, 1997). Accordingto the EBRD (1997), the privatesectorhad grownto accountfor 70 percent of Russia's GDP by 1997, while the Ukrainianprivatesector only delivered 50 percent of GDP in that year but slowly expandedto 60 percent by 1999 (EBRD, 2000). The combinationof a growingprivatesector and the enhancement of propertyrights amountto a threatto the old habits of rent seeking. Certainstate bodies also need autonomy,especially regionaland local organs, from the centralstate.Today,they have little independenceand thus responsibility, while the center is unable to supervise them, which inspires cheating by local organsand arbitraryrule by the center.Most taxes are sharedbetween two or three administrativelevels in a shifting and arbitraryfashion, which leads to additional tax revenues of regional organsbeing confiscatedby the central state (Kravchuk, 1999). Ideally, each tax would be fully allocated to one administrativelevel, for instance,VAT,excise taxes, and foreign tradetaxes to the centralstate, and property taxes to local authorities.To make the division crystal clear, each tax base should be allocated to one administrationlevel, and each kind of expenditure should be entirely financed by one level, for instance, defense by the central government,but schools by local organs. Finally, the state tax service should be dividedbetween the threeadministrativelevels as well to clarify responsibilityand accountability(Shleifer and Treisman,2000). Fiscal autonomywould encourage competitionbetween differentadministrativelevels. A large numberof privateenterprisesare needed to supportpolitical competition. Autonomy for small entrepreneurshas empirically proven rather easy to create. Essentially, only two things are needed-a simplified registrationsystem and a simple lump sum tax. The early introductionof wide-scale lump sum taxes spearheadedthe evolutionof many small privateenterprisesin Poland,which later formed the social, political, and economic base of radicalmarketeconomic transition (Aslund, 1985). In 1998, Ukraine successfully launched a fixed lump-sum tax for small entrepreneurs.It has stimulatedthe developmentof millions of small enterprises,which will be the base of a true marketeconomy. If the state is characterizedby rent seeking, state resourcesare used for private enrichmentandthe repressionof enterprise.Then,falling staterevenuesaredesirable to limit rents.Withfalling state revenues,resistanceagainsta rationaltax reformis also likely to fade, as leadingrentseekerswill no longerperceivea cumbersometax system as an effective deterrentagainstbusinessby outsiders.Or they might be too weak to block a liberal tax reform. Thus, Georgia, Kazakhstan,and Kyrgyzstan undertookradicaltax reformsafterstaterevenueshad fallen sharply. It is not enough, however,thatstate activitiesare cut for a lack of funds. Public mandates must not be left unfunded but rather eliminated. A major cause of corruptionis that semiautonomousstate organs try to raise their own revenues to 102 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

THEUNDER-REFORM ESCAPING TRAP

finance state programsthat remain on the books but are no longer funded by the central government(Rose-Ackerman,1999). Such public fund-raisingis usually undertakenthrough extortionaryfees and penalties, being the most ineffective taxes and amountingto a majorcause of corruption. The most plausibleinterpretationof growingbarterand arrearsup to 1998 was that they formed a mechanismof extractinggovernmentsubsidies and then privatizing these subsidies through management theft. Total enterprise subsidies amounted to no less than 16 percent of GDP in 1998 (Pinto, Drebentsov, and Morozov, 1999). Otherwise,the cost of a barterdeal should be deterringat about 25 percentof the deal (Djankov, 1999, p. 131). This extractionof implicit subsidies throughbarteris facilitated throughits nontransparency.With the financial crash in Russia, barterfell like a stone from 54 percentof all interindustrytransactions to 21 percent in August 2000 (Russian Economic Barometer,2000). A parallel development has occurred in Ukraine. The government was forced to hardenits own budget constraints,demandingtax paymentsin cash, which eliminatedthe possibilities to extracttax rebatesthroughbarteror offsets. The effect of the dwindlingbarterhas been not only greatermonetizationbut also a leveling of the playing field, intensifiedcompetition,and economic growth. One of the most erroneous ideas in much of the transitionliteratureis that political and economic continuity are vital, because a valuable administrative capitalexists thatmust be utilized (Stiglitz, 1999). On the contrary,a maximumof discontinuityis desirablein both the political and economic spheres. The EBRD (1999) TransitionReport 1999 shows that the greaterthe discontinuity in the ruling elite, the more radical and successful the marketeconomic reform.Progressin liberalization"was twice as high in countrieswhere the political executive was replaced as in those where the incumbentfrom the communist era remainedin office" (p. 106). Transitioncountrieswith more competitivepolitical systems and more unstable governments have tended to achieve greater progressin economic reform.The five transitioncountrieswith the most frequent changes in governmenthave been the threeBaltic States, Poland, and Bulgaria,of which four have been among the most successful reformers(p. 112). The apparent explanationis that turnoverof personnel leads to greatertransparencyand more checks on corruption.The greaterturnoverof governmentscan also be seen as a reflection of more effective democracy,one of the best checks on a rent-seeking elite (see Figure 1). The same is true of certaineconomic discontinuity.Drazen and Grilli (1993) have modeled how economic crises may facilitatereformby underminingharmful vested interestsboth financiallyandpolitically.The Russianfinancialcrashundermined the ruling oligarchy, thus facilitating substantialreforms, notably budget and tax reforms,which contributedto unexpectedeconomic growth in 1999 and 2000. Thanksto its hyperinflationof 1996-97, Bulgariachanged political leadership through democratic elections and undertookfar-reachingliberal economic reforms, seemingly breakingout of its under-reformtrap.The Romaniancrisis of 1996-97, on the contrary, does not appear to have been sufficiently severe. Insufficientreformsproved ineffective and allowed the comeback of ratherunreformed communiststhroughdemocraticelections in 2000. 103 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

AndersAslund,PeterBoone,and SimonJohnson Economically, market reform in Russia and Ukraine has proceeded. Both countriesare now liberaland open economies with largeexportsin relationto their GDP (see Table 2). Some monopolies are truly natural,but they can be structured to reduce rent seeking. For example, the power companies in Russia are aligned with individualregions, and regionalgovernorshave substantialcontrol over tariff setting and personnelappointments.Therefore,these companieshave become the fiefdoms of regional leaders, who typically keep tariffs low, prohibit electricity companies to cut off local enterprises,and force them to supply regional governments for free. If several regional companies are merged, they fall outside of the control of each governor. A popularidea in attemptsto reducecorruptionthroughadministrativeharassment has been the attemptedestablishmentof one-stop shops for licensing and foreign investorsin variouscountries,but such efforts run counterto the competitive approachand they have failed in many countries,as this implies a monopoly of corruption.Instead,severalagencies could be allowed to issue the same licenses andpermits,promptingthem to providebetterand cheaperservices in competition with one another.For example, a visit to Bishkek in 1998 revealed that the city architecthad swiftly registeredall land for housing and issued titles for the land, because two competing agencies were doing the same, and it was enough to get title from one of them. Similarly, enterprisescould be allowed to register with different agencies, as long as multiple registrationsare not required.Organs at federal, regional, and local level could all be allowed to issue all licenses that exist. The basis of civil society is public learning,which is probablya reason for the brevity of each method of rent seeking. As people have understood,reformshave become necessary.Eitherfollowers havejumped into the game to make money for themselves, for instance, driving rents down through arbitrage,or others have reacted against the rent seeking and demanded structuralchanges. For instance, cheap credits could be publicly defended in 1992 in Russia and Ukraine, but everybody knew they caused hyperinflation by 1994. The quality, and thus freedom, of the media is crucial for this public learning.Besides, much of the old rent seeking has been built on structuralinertia and fear of change, but as the necessary structuralchanges proceed throughdownsizingby default,many obstacles to reformfade away. Our line of argumentfits the model of DaronAcemoglu and James Robinson (2000) of political losers as barriersto economic development.They argue that socially beneficial economic reformsare being blocked, "whenthe political power of the incumbent is threatenedby economic innovation"(p. 128). Their model indicatesthatthe incumbentmonopolistis more likely to block the introductionof new technologies when political rents from staying in power are greater,when monopoly profits from blocking are greater,and when the tax revenue they can collect from rivals are smaller.While this paperdiscusses an oligarchyratherthan a monopoly, it shows how this confluence of political and economic oligarchy works in practice. A corollaryof this reasoningis thatan oligarchyis muchbetterthanmonopoly and dictatorship.BelarusandTurkmenistanpresenta far more stableunder-reform 104 This content downloaded from 130.237.165.40 on Tue, 24 Nov 2015 21:24:52 UTC All use subject to JSTOR Terms and Conditions

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trap, which is held together by an iron triangle of 80 percent state ownership, minimal liberalizationof the economy and full dictatorship(EBRD, 2000).

IV.Conclusions Russia and most formerSoviet republicshave actuallybecome rathernormal marketeconomies, because most marketeconomies have weak rule of law, a few dominantbusiness groups, and a close relationshipbetween governmentand business. Russian and Ukrainianlevels of corruptionand political conflict are not unique. They have fallen into a fairly common trap: high corruptiondrives the economy undergroundand offers few incentivesto enterthe official economy.We have discussed this as an under-reformtrap,but this is really a special case of a more general developmenttrap.3 There are three possibilities for marketeconomies trappedwith weak institutions. First, there may never be growth, as has been the experience in much of Africa for decades. Second, if it is in the interest of some part of the elite, some growthmay occur, and this createsthe incentivefor managersand governmentsto behavebetterand steal less. Growthbecomes self-fulfilling and self-supporting,as in poorerparts of Europe over the past 40 years. Eventually,institutionalreform occurs, but it usually requiresthe involvementof a thirdparty (like the European Union). Third, rapid growth may alternatewith episodes of economic collapse. This has been the experience of LatinAmerica over the past 40 years, and it may now be the case of East Asia. Institutionscannotbe built withoutpolitical demandsfor institutions,and such demandsdependas much on the natureof the economic system as on the political system. For a dictatorshipor business hegemony, any institutionis harmful,as it implies a reductionof absolutepower.An oligarchy may find an equilibrium,but it is potentiallyunstable,as is an oligopoly. The question whetherthere is a sufficiently strong demand for sound market economic institutions in Russia and Ukraine is a question whether the economic and political pluralism is strong enough to allow these countriesto breakout of theirunder-reformtrap.The financial crash in Russia broke many oligarchs both financially and politically, while broadeningthe numberof big businessmen.It also increasedthe demandfor stable financial institutionsin all groups of society. Meanwhile, increasing competition is bound to reduce rents, and eventuallyrent seekers may opt for profits instead. The driving force of positive change has to be entrepreneurswho feel they are at a disadvantagebecause of the privileges of others.

3Forevidenceon the importanceof institutionsin economicdevelopmentmore generally,and the long-lastingeffects of earlyinstitutions(such as how a countrywas colonized),see Acemoglu,Johnson, and Robinson(2000). Forthe size anddeterminants of the underground economyaroundthe world,see Friedmanandothers(2000).

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