Trust and Taxes: Estonian and Lithuanian Fiscal Performance During the Crisis
27 Pages Posted: 13 Jul 2012 Last revised: 27 Aug 2012
Date Written: 2012
The paper aims to explain the difference in fiscal performance between Estonia and Lithuania (Latvia is also discussed) – two countries that were among the hardest hit ones during the recent economic crisis. While Lithuania (and Latvia) saw its budget deficit and public debt expand substantially, Estonia managed to keep the deficit under 3 percent of GDP and consequently was invited to join the eurozone as of 2011. The experience of these countries presents an interesting puzzle, as the divergent fiscal performance cannot be attributed to purely economic factors. Both countries have similar economic structure, and both were similarly affected by the crisis. Furthermore, expenditure reduction efforts fail to provide an answer either, as Lithuania actually cut budget expenditure more than Estonia did.
It is therefore argued that the proximate cause for the different fiscal performance was related to tax revenues which decreased much less in Estonia than in Lithuania. Since tax policy changes in both countries were also similar, the answer lies in tax compliance gap between these countries. In turn, the paper argues that this compliance gap can be attributed to different quality of institutions in Estonia and Lithuania, in particular the level of trust in political institutions. Lithuanian society deeply mistrusts its government, while Estonian authorities are significantly more popular. As both countries implemented harsh austerity measures during the crisis, Lithuanian society did not present open contestation (in terms of protests or electoral backlash), but resisted (or at least did not support the consolidation policy) by turning to shadow economy.
The paper uses comparative, within-case and cross-case analysis to solve the empirical puzzle. Inter alia, it relies on “nested” analysis by placing the Baltic countries into comparative context (EU member states). This helps to, first, solve the particular Baltic puzzle and, second, provide more general insights. In particular, it is hypothesized that the importance of trust for fiscal performance might even increase during economic downturns. In other words, the relationship between trust and tax compliance might be conditional on the economic environment. Finally, an implication for Lithuania is that the solution of certain seemingly economic problems, such as increasing public debt, might require an improvement in the state-society relationship.
Keywords: Economic crisis, Estonia, Lithuania, trust, fiscal
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