In 2004, the post-Soviet Republic of Georgia embarked on an 7-year overhaul of their taxation system. The government attempted to move from a method of revenue collection that was complex and progressive to one that was simple and transparent. The results have been fantastic. Tax compliance is on par with the most developed countries around the world, and much higher than other former Soviet countries. All of this was accomplished with a program that, on the surface, was contradictory to all of the best evidence-based scholarly research on the topic. The inherited wisdom that we have gathered from sociologists, economists and political scientists is that in order for citizens to feel compelled to take part in the collective project of the state, then the tax system needs to be eminently "fair" and "just." Tax is understood to be just when those with the highest ability to pay are burdened with the most taxes, and this is generally achieved with progressivity, movable rates based on levels of income or the value of the taxable object (property, investments, etc.). Then why has this tax reform been so successful in Georgia? What has made these changes induce more compliance, when there is theoretically less tax justice in the country?
Let's start with the established ideas from political science and economics on what taxes should look like and see if Georgia's reform matches up.
Adam Smith's classic tome The Wealth of Nations (1776), famous for its laissez-faire thesis, covers a wide range of topics. And taxation is such an important subject, it is no wonder that he provided an outline of the basic principles upon which all tax systems should be based. They can be summarized as follows:
1. Taxpayers should pay an equal share relative to their ability to pay and/or benefits received from the state
2. Taxes should be clear and not arbitrary
3. Taxes should be collected without physical pain or complication
4. Taxes should have low administrative costs
In sum, Smith suggests that taxes should be fair, transparent and easy to collect. Though not always accomplished, these principles have guided modern tax policy for the last two centuries. These ideas still undergird the policy advice that is given to developing countries from aid organizations and international financial institutions (OECD, World Bank and IMF).
The reason that these principles have continued to be relevant up to today go beyond some putative morality, the expectation is that if taxes are perceived as fair then people will be willing to pay them. "Justice" also means more money for the state. This also assumes the opposite, that if taxes are "unfair" then people will be unwilling to pay.
The received wisdom of the social sciences assumes that each of us, as individuals, goes throughout the world calculating rationally, and so taxes should not be any different. For example, economists and political scientists tell us, that if we understand how we can benefit directly from paying taxes, then we will happily pay those taxes. So let's say I am made aware (by an advertising campaign) that my tax dollars are used to keep my life and liberty safe, then theoretically I'd be willing to contribute to a fund (the government's budget) in order for that to happen. But the fact is that very few people actually think in these terms. Most people will try to avoid paying taxes as much as they can, regardless of the potential benefits they may reap.
The dominance of the rational "homo economicus" ideal has meant that the advice given to developing countries around the world has been to work towards a model system of taxation based on the United States or Great Britain. In essence, that is a system heavily reliant on progressive income taxes and bolstered by universal democratic institutions (including local ones) to stave off abuse. Progressivity and a reliance on taxing income as opposed to spending, are assumed to result in more just taxation. The people in society who have a higher ability to pay will be more burdened with tax according to this type of system. Excise taxes and other sales taxes tend to be regressive because they bake in extra costs to the basic products that all citizens purchase. (Unless, of course, excise taxes and import duties are only applied to luxury items). Georgia's tax reform did not follow this model, it was rather a neo-liberal (or even libertarian) fever dream.
After the fall of communism, the country inherited a system of progressive taxation in which the wealthiest individuals and businesses were expected to make the largest contributions. In addition, the country supported a generous welfare program that was paid for by social contributions that were paid in partnership between businesses and individuals. Indirect taxes also played a large role in the old system, with excise taxes on all types of everyday items and large customs duties ranging between 12-70%.
The reforms lowered taxes across the board, eliminating many of them outright. All progressivity was flattened out, so that each taxpayer would contribute the same percentage of their income, regardless if they were street sweepers or billionaires. Excise taxes remained on only a few items, such as alcohol and tobacco. Overall, the system went from twenty-two different levies and taxes applied to individuals and businesses to just six. Georgian taxation certainly became simplified, clear and transparent through these reforms, but this new set of taxes introduced implied injustice. The statutory tax burden shifted towards the least fortunate. And yet citizens were far more inclined to pay their taxes than they were prior to the reform. Compliance went from 35% to 85% in a matter of six years. Let's take a look at the results.
This first graph shows the rise in tax revenue as a percentage of GDP. Tax revenues shot up in real terms and against GDP even as the country's economy grew precipitously.
Tax revenues in real terms: Georgian Lari. (1 Lari is worth around 0.35 USD).
This pie chart below from the Georgian Ministry of Finance shows the spread of the tax burden. It shows a clear reliance on VAT and personal income tax (corporate income tax is conspicuously absent). Both of these sources of revenue are inherently regressive, in that they burden the poorest in the society much more than the wealthiest. VAT is a sales tax that allows the onus of payment to fall onto the so-called "final user" of a given product. When a business purchases items and uses them for their purposes, they are allowed to deduct that VAT amount from their own tax obligations. However, individuals making purchases for their own use (food, cosmetics, etc.) are all liable for VAT. The personal income tax, as mentioned before, was turned into a flat tax, requiring paupers and billionaires to surrender the same percentage of their income.
The government reformers focused policy changes on attracting business and simplifying the tax code. But as I mentioned before, they actually took away elements of fairness and justice that were present in the previous laws. Clearly these changes were a boost for the overall economy, but I am interested in the question of compliance. The same Georgian citizens who just a few years prior were lying and cheating in their dealings with tax authorities, now submit honest self-assessments every year, and even pay their taxes on time. So what changed to make this happen?
That story actually lies outside the tax laws and into an overall understanding of the way that citizens viewed their state. People gained trust in their government for a different reason entirely: the eradication of corruption.
Georgia, like nearly all post-Soviet states, was rampant with corruption and waste in the years of transformation into a free-market system and republican government. The rot of bribery and lawlessness pervaded nearly every interaction that citizens had with functionaries of the state. In 2003, Georgia was ranked in the bottom ten of the world's most corrupt countries in the world.
Reformist and pro-Western president Mikheil Saakashvili took power that same year and introduced perhaps the most aggressive anti-corruption campaign ever. In a matter of months, the interior ministry sacked over 30,000 government employees, including the vast majority of the police force. On a single day about half that number were forced out of their jobs. New recruits were brought in at higher wages and the government introduced harsh punishments for accepting bribes. As one might imagine, emptying out the entire law enforcement community was a risky proposition, but it paid off.
According to a Georgian government report from 2011, the country ranked the highest in the world in public perception of the reduction of corruption. So the story here is less about the type of tax system adopted – an issue that should be closely connected to the economy and society – and more a tale of the reduction of corruption. In transforming the public perception of their state, Georgian reformers were able to communicate to citizens that the state could be trusted and therefore was worthy of their hard earned money.
This change in public perception of the representatives of the government, starting with the police, had far more impact on the willingness of people to pay their taxes than the content of tax reforms. Those tax reforms helped usher in a new era of economic growth and encouraged businesses to invest in Georgia, both domestically and from abroad. Ultimately it was Saakashvili's reform of the administration and police that guaranteed citizens' consent, cooperation and compliance.
The two then reinforced each other. As the state had more funds, they could finally afford to pay police officials and treasury administrators.