Efficiency Losses from Tax Distortions vs. Government Control

Abstract

Why has the rapid privatization of firms in Eastern Europe and the former Soviet Union not brought dramatically higher performance as expected? If private ownership were so clearly dominant, why has state control of enterprises been such a common phenomenon historically, even in many Western countries? In this paper, we argue that with private ownership, any price distortions (whether from high tax rates or explicit price controls) generate efficiency losses roughly proportional to the square of the implicit tax rate. In contrast, the efficiency loss under state ownership should be largely independent of these implicit tax rates. Therefore, the efficiency loss from state ownership can be less than that from private ownership when price distortions become large enough. Historically, there does seem to have been a close association between state ownership and high tax rates. For good reasons, privatization is normally associated with sharp drops in tax and nontax distortions. When privatization occurs without a substantial reduction in tax rates, as in Russia, efficiency costs from the high tax rates have been obvious, raising questions about the internal consistency of this set of policies.

JEL Classification: H21, P21