* 11

percent for Portugal, 3 percent for Argentina, and _5_ percent for Israel.' Countries with younger demographic structure but similar income level spend even less. Expenditures as a share of GDP are expected to continue rising for the foreseeable future, as a result of a continued aging of the population. This raises a serious affordability issue. Faster transition to the market economy will only worsen this problem.

Under central planning, transfers of up to 10 percent of GDP for pensions appeared affordable. Government revenues and expenditures were typically about 50 percent of GDP, and these were extracted directly from state-owned enterprises by state-owned banks, so tax administration was relatively simple. This efficient and effective **tax** administration has changed as market forces have been introduced. Banks are not willing to collect taxes, so administration system has to be built up from scratch. As a result, tax revenues are shrinking rapidly.

Many EECA countries consider the current fiscal crisis temporary, caused primarily by the need to improve administration. However, EECA countries should not expect to return to previous revenue levels in a mixed system or market economy, as it is neither deirable nor feasible for the government to collect such a large share of GDP in taxes. It is not desirable because taxes distort economic incentives, stimulating unproductive rent-seeking activities and lowering the rate of economic growth. Higher tax rates distort more, causing more evasion, requiring more resources devoted to adminitation and therefore collecting less net revenue. It is not feasible because there are practical limits to tax administAt in a market economy, where economic activity is decentrlized. Most countries with a GDP per capita of about US$2000 are only able to collect 23-25 percent of GDP in taxes, below the average in OECD countries. This is because tax administration systems are typically weak, and wage income (on which it is easier to collect taxes than rents or profits) is a smaller share of GDP than in OECD countries.

EECA governments need to adjust their expenditure promises to meet a more realistic revenJe celing. Assuming that EECA governments face an overall tax ceiling of 25 percent of GDP, collecting one-third to one-half of this potential revenue in payroll taxes and spending it on pension benefits appears unwise. On the expenditure side, all EECA countries face urgent needs for govemment spending. Hospitals need rehabilitation, school need an overhaul and teachers need training, the communications infrastructure is inadequate for participation in the international economy, the unemployed need to be retrained, crime needs to be prevented, etc. At the same time, the high payroll taxes have already encouraged evasion and avoidance, resulting in a shrinking tax base. For example, in Poland in 1992, an estimated 10 percent of the non-agricultural labor force evaded payroll taxes. Arrears among those who did pay are also climbing. Raising payroll taxes to finance increasing pension expenditure is not likely to resolve the affordability problem, but will instead reduce employment in the formal sector and accelerate the development of the underground economy, exacerbating revenue collection problems for the whole tax system.

' 'Me EECA numben are from Table 2 and are mostly 1992; the data on other countries are from the World Bank Old-Ag Security Project database and are 1989.