Legality and Market Reform

in Soviet-Type Economies(1)

John M. Litwack

"Who's the Boss: we or the law? We are masters over the law, not the law over us so we have to change the law; we have to see to it that it is possible to execute these speculators!"

Nikita Khruschev (1961)(2)

The classical Soviet-type system operates in the virtual absence of economic legality, which is a prerequisite to a successful transition to a market economy in the Soviet Union and the nations of Eastern Europe. In the absence of economic legality, the leadership of these countries will not be able to implement a credible commitment to private property rights or any other effective market incentive mechanism. In addition, they will be unable to promote the growth of multilateral impersonal trade. Without legality, a shift away from central planning toward market allocation may very likely lead to economic decline, inflationary pressures, and a polarization in income distribution, which, in turn, could unleash political reaction against the reform process in general.

This paper begins by introducing a working definition of economic legality, and then contrasting such legality with the systems of coordination, incentives, and distribution in the classical Soviet-type economy. The paper then argues the vital necessity of establishing economic legality in the transition period, and outlines some important difficulties. Finally, the experience of the Soviet economy is briefly examined, where it is suggested that the failures of recent years derive, in large part, from these same difficulties.

A Definition of Economic Legality

"Legality" is associated with rule by law as opposed to the discretion of leaders. Recent research in economic history has emphasized the importance of the replacement of legal for discretionary rule in explaining the rapid economic development of the western world, as well as the disparities in wealth between the advanced capitalist and underdeveloped countries.

This paper will employ the following two-point working definition of legality: (1) a mutually consistent set of laws; and (2) a belief by the population in the stability and enforcement of these laws.

Notice that the presence or absence of legality in any given country is a matter of degree in this definition. In addition, according to the second condition, legality is a social phenomenon depending on the beliefs of the population. Instability or the lack of enforcement of laws does not necessarily imply an absence of legality, and the presence of consistency, stability, and enforcement is not sufficient to imply legality, unless the population believes that these respective legal climates exist and will continue.

"Economic legality" refers to laws in the economic sphere, particularly contract, tax, and bankruptcy laws. Although reforming socialist countries, especially the Soviet Union, have been writing and rewriting such laws at a mind-boggling pace in recent years, these countries have not yet succeeded in building genuine legality.

The Classical Soviet-type Economy and Legality

It is impossible to comprehend the difficulties in the current transformations in Eastern Europe without an understanding of the functioning of the classical Soviet-type economic system. This system contains particular mechanisms of coordination, incentives, and distribution that function in the virtual absence of economic legality. The fundamental features that explain how the system actually works are the discretionary power of bureaucrats over subordinates, enforced by the political dictatorship of the Communist Party, and the reputation effects from personal, often informal, long-run ties.

In a modern capitalist economy, hierarchical organizations interact in the context of a market. In a Soviet-type economic system, any existing market activity functions in the context of a large administrative hierarchy. This hierarchy largely replaced the market in coordinating economic activity between individuals and organizations.

The fundamental document for implementing an administrative allocation of resources is the yearly material-balance plan, which emerges through extensive bargaining between various levels in the hierarchy. Superiors in the hierarchy, who have the last word in this bargaining, typically press for greater output and less inputs while individuals at the lower levels, in possession of local information, lobby for the converse. The plan primarily specifies yearly flows of inputs and outputs, as well as an allocation of government investment. The basic method of plan construction is marginal adjustments based on what was achieved in the proceeding year. Once this plan has been drafted, it is given the status of law, and underfulfillment of the plan is technically a violation of law. Thus, the Soviet-type coordination mechanism on paper appears to rely on legality, with the yearly plan as the fundamental legal document.

In reality, a forceful argument can be made that little legality in material-balance planning exists in the Soviet-type system. The plan is important in specifying an initial division of resources. But after it is drafted, a process of continual adjustment begins in which bureaucrats continually employ their discretion in changing production orders and redistributing resources. As stressed by many specialists, these continual discretionary adjustments and reallocations are a prerequisite to the very feasibility of Soviet-type planning. The hierarchical structure of power in the Soviet system also implies that these adjustments can be made unilaterally. The fact that the plan is so unstable has led some scholars to prefer the term "centrally managed" or "administered" in describing the Soviet-type economy, rather than "centrally planned." In addition, plan underfulfillment is a common occurrence and not treated as a violation of the law in practice, although, as discussed below, there often exist significant incentives to fulfill the final version of the plan. Thus, the plan is generally not stable or mutually consistent, and although it does affect behavior, it does not satisfy the criterion of legality.

Given the plan, an intricate web of personal horizontal contacts comes into play in coordinating economic activity, which contrasts sharply with the multilateral impersonal trade that is commonly associated with a developed market. This is not to argue the unimportance of personal relationships in a market economy. But the protection of trade by legality significantly decreases the need to depend on these relationships. Virtually every Soviet-type enterprise has an employee that works as an expeditor (tolkach), whose primary responsibility is to establish long-run personal relationships with other organizations for the purpose of procuring needed supplies, particularly in emergency circumstances. The presence of these informal relationships is critical to the coordination mechanism of the economy itself. It is well-accepted that it is impossible to be a successful manager in a Soviet-type economy without continually breaking the law and relying on these personal contacts. In the consumer sector, citizens commonly rely on "pull" (blat) through "acquaintances" (znakomstvo) to obtain goods and services. Again, this features mostly long-run mutually-beneficial relationships between individuals. In these relationships, trust can be maintained, even in the absence of legality, through reputation and a mutual advantage to continuing transactions.

Of course, market transactions between individuals without well-established personal ties can also occur in the Soviet-type system. The most common example are the small number of legal markets, such as farmers' markets and flea markets (barakholki). Street vendors sometimes engage in semi-legal or illegal indiscriminate sales of goods. But given the fact that market transactions in the Soviet-type system are, by and large, illegal and contract violations cannot be prosecuted, the transaction costs associated with impersonal trade can be prohibitively high, which favors long-run personal ties as a primary means of horizontal transaction. A major dilemma of the reform period has been the inability of the leadership, by legalizing this trade, to significantly reduce these transaction costs and also make market transactions subject to taxation.

Vertical relationships between superiors and subordinates in the Soviet-type system also tend to be highly personal. Subordinates commonly give large gifts (prinoshenie) to superiors in the ministerial and party apparatus. These gifts are generally not bribes in the sense of being a direct exchange for specific goods and services at one moment in time. They are an investment in a long-term personal relationship. In addition, special orders are continually fulfilled for superiors or other important personal contacts at the expense of all other work.

Incentives in the Soviet-type economy include pecuniary rewards, communist party discipline, and the system of promotion and demotion (nomenklatura) in the Communist Party hierarchy. A claim of this paper is that nonpecuniary incentives are actually more important than pecuniary ones in the Soviet-type system. Virtually all management positions in economic organizations belong to the nomenklatura network of appointments, promotion and demotion in the party hierarchy. In addition, virtually every economic organization in the classical Soviet-type system possesses its own internal party committee that engages in monitoring and the enforcement of labor discipline. In the past, mobilizations and massive propaganda campaigns, as well as terror and coercion, have been used in the context of this nonpecuniary incentive system. The incentives provided through this system, however, have become less effective in the Soviet Union since the 1950s, as well as in the countries of Eastern Europe. Regardless of the degree of effectiveness, the incentives provided through the party hierarchy are devoid of legality. They are oriented toward the obedience of orders that are given at the continual discretion of superiors.

In discussing compensation for workers and managers, it is important to distinguish between official and underground channels. Neither operates on a basis of legality, the first because of instability and continual violations of rules and regulations, and the second because of explicit illegality.

On paper, the official pecuniary reward system involves elaborate bonus and tax schedules. Bonus funds as well as salaries can be withdrawn from the government bank as cash by organizations as opposed to the earmarked blocked funds. Over half of the pay of managerial personnel can depend on bonuses that are functions of performance that are typically tied to the plan but also can depend on profits, productivity, cost reduction, technical progress and other variables. In the postwar period, organizations have also been given the right to carry out limited decentralized investment as a function of profits and other measures of performance.

In reality, salaries, bonuses, and other decentralized funds are regulated on a discretionary basis, with the purpose of expropriating excess profits from organizations that reveal themselves to be more productive and guaranteeing "normal" salaries and bonuses. Often in explicit violation of regulations governing stability, norms and tax rates are continually adjusted for this purpose. The adjustment in tax rates is often realized implicitly through numerous policy variables such as fines (sankstii), the distribution of various types of funding, and differentiation in prices that different enterprises receive for the same commodities. Prices are also subject to comprehensive periodic adjustments. The essence of this system is captured by a Russian word that found its way into the vocabulary of all the Eastern European countries: uravnilovka, which translates as "equalization" or "levelization." Uravnilovka is qualitatively quite different from an explicit dynamic tax scheme, which would imply the presence of economic legality. Under uravnilovka, actual tax rates and norms are continually set and adjusted only after superiors in the hierarchy observe existing conditions. Inequalities are observed and subsequently leveled off.

This important after-the-fact connotation of uravnilovka is also captured in another commonly used description of the distribution system: "The principle of one big till (kasa)." Everything is first centralized and then divided up or, as Soviet bureaucrats often remark: "We first undress enterprises and then think about how to dress them up at least a little." The distribution system is therefore also devoid of legality as defined in this paper. It is unstable and often in direct violation of written regulations that are meant to govern the stability of norms and taxes. The absence of an independent judiciary in the Soviet-type system also implies that economic organizations have very limited means for seeking redress for violations of written regulations. Such an action could also jeopardize the vitally important personal relationships that subordinates must forge with their superiors.

Market Reform and Legality

It is sometimes suggested that the complex network of horizontal personal ties that exists in the socialist economies may already provide a foundation for the creation of a market economy. In a sense, markets already exist. They simply need to be legalized, expanded, and improved; the high transaction costs imposed by the classical Soviet-type system need to be reduced. But at least two fundamental problems must be confronted here. First, institutions to support legality are needed to facilitate flexible, often impersonal trade that could replace, to some degree, the reputation effects from personal relationships in promoting cooperation. Second, the former system of uravnilovka must be replaced by genuine profit incentives, which will substitute for nomenklatura and party discipline in motivating economic activity. The remainder of the paper will focus on the second problem.

The preceding discussion of the classical system immediately suggests difficulties in creating profit incentives. If managers in Soviet-type economies could be characterized as bonus maximizers, as is suggested in some studies, creating profit incentives would be a straightforward exercise, involving a shift in emphasis in bonus schemes from the fulfillment of central directives to profits. But this is simply not true. Effective legal pecuniary incentives of any type do not exist, and therefore must be built from scratch. The primary task facing central authorities is the credible commitment to stable sharing rules for profits and losses between the government and individual organizations. This, in turn, implies the creation of economic legality. At least five major interrelated obstacles must be overcome:

The Reputation of the Past Leadership and Adaptive Expectations. The history of reform in the USSR has featured continual broken promises by the government to establish commitment to stable pecuniary incentives. Other Eastern European countries have had similar experiences. The population has already become accustomed to an environment of uravnilovka, devoid of legality, where written commitments are not honored. It should be noted that genuine private property rights, now a goal in many of the socialist countries, cannot exist in an operational sense without legality in taxation. The current changes of political leadership in many of the socialist countries may help in altering the expectations of the population. But given the reputation of past leadership and the orientation of the population to a society without legality, beliefs may not change rapidly. As discussed above, legality depends on the beliefs of the population. Those countries with political leaderships that have most clearly signalled a break for the past have a natural advantage in affecting these beliefs. But it is crucial that new leaders do not begin by tarnishing their own reputations for upholding commitments.

Ideology. In the socialist countries there is a general orientation, supported by Marxist-Leninist ideology, against private entrepreneurs and "speculators." ...[B]ut even in the absence of communist power, the social atmosphere may remain anti-entrepreneur. In the USSR, for example, potential entrepreneurs are not only afraid of the political leadership, but their own neighbors who may decide to carry out their own notion of social justice.

Personal Ties and Tax Evasion. The presence of the large network of underground horizontal ties in the socialist economies poses a potential threat of institutionalized tax evasion. This is further complicated by the lack of an internal revenue service, reflecting the fact that the classical Soviet-type system conducted taxation in the legal economy automatically through the central bank. Only income net of taxes could be withdrawn.

The Time-Inconsistency of a Successful Transition Program and the Instability of the Transition Period. Given the complex nature of the transition from administrative to market resource allocation, it is natural to expect discretionary behavior on the part of the leadership that must continually adapt to new information and conditions. But complete discretionary behavior contradicts legality and stable sharing rules for profits, losses, and risks between the government and other organizations. After the fact, the government has an incentive to absorb surpluses from organizations that reveal themselves to be very productive and profitable. If organizations expect future profits to be taxed away, they may simply choose not to become profitable in the legal economy.

Regional Autonomy and the Division of Authority. Many of the reforming socialist economies have struggled with the emergence of defiant regional authorities that often set their own laws and regulations in conflict with central legislation. This threatens the necessity of a mutually consistent set of laws for the establishment of legality.

The Soviet Experience

These [five] trends have caused the rapid deterioration of the incentive mechanism of the classical Soviet-type system. Although the institution of yearly central plan has remained, there has been a general breakdown in coordination and plans have commonly gone underfulfilled. Many economic organizations have been encouraged to plan their own production, sell directly to consumers, and retain a portion of the profits. A series of decrees in 1987 first proposed a comprehensive transformation to a market economy that features decentralized trade, pricing, and profit incentives. These decrees centered around a new "Law on the State Enterprise." For the criterion of strong incentives, this law prescribed stable taxes for a five-year period.

Soviet reform efforts have also sought to expand the legal private sector. This began with the expansion of opportunities for small cooperative businesses in 1986 and a "Law on Cooperation" in 1988 that declared cooperative property rights to have the same legal status as government property. As with the state sector, profit incentives were to be protected by a clause in the law that guarantees stable tax rates for at least a five-year period (sec. 21, art. 6). More recently, the Soviets have expanded opportunities for nongovernment property rights, promoting first long-term leasing and now joint stock companies and small private businesses.

Despite these and other measures, the Soviet economic situation has deteriorated at an alarming rate in the last few years. Budget deficits have spiralled out of control since 1985, leading to an increase in government debt from about 15 percent of GDP to 50 percent in 1990. Crime has increased sharply. Moreover, there has been a significant polarization of the income distribution, which makes inflationary pressures quite threatening for the poorer segments of the population. The current decline and crisis in the Soviet economy can be explained primarily by the fact that, despite the plethora of recent laws, the Soviet leadership has made no progress in establishing economic legality, and no effective incentive mechanism has replaced the declining authority of the party and ministerial apparatus.

The history of legislation in the Gorbachev period has been entirely inconsistent with legality. Virtually every law, for example, that has promised stable taxation to eliminate uravnilovka and make profit incentives operable has been overtly violated or revoked to the preservation of the discretionary expropriations. This includes the 1987 package of laws and subsequent legislation, including all promises of stability in taxation discussed above. The absence of legality and corresponding beliefs by the population that profits will be expropriated and losses compensated has led many Soviet enterprises to respond to less central planning and party discipline by reducing activity in the legal state sector of the economy. This decline in the state sector and tax evasion in the nonstate sector decreases government tax revenue, which feeds into the deficit crisis. The Soviet leadership has responded to this revenue crisis by making discretionary changes in tax laws, including the introduction of very harsh "emergency measures" since 1989 to absorb surpluses from profitable organizations. While ratios of government expenditures to GNP have actually been declining in the USSR since 1987, the widening deficit can be explained by greater declines on the revenue side.

The legal private sector has been the hardest hit by the continual policy reversals and emergency measures. Measures by various authorities to expropriate rents from this sector have been reinforced by a general witch-hunt atmosphere for "speculators." The remnants of communist ideology have no doubt contributed to this orientation, but it is also true that the distorted environment of the transition period has served to justify suspicions of private entrepreneurs. The most profitable ventures have typically involved, to one degree or another, arbitrage profits from the diversion of state resources at low or negligible prices to the private sector. Perhaps the most profitable and popular activity of Soviet cooperatives is to pump (perkachat) money illegally from earmarked blocked investment funds into cash through the cover of a contract between a cooperative and a state enterprise. A state enterprise pays the cooperative out of its own blocked investment funds or earmarked bank credit, which the latter organization can withdraw as cash. A serious argument can be made that activity in the private sector has generally contributed to the current economic crisis. Efforts have been diverted away from value-adding activities to arbitrage and tax evasion, which has polarized income distribution. As market activity has expanded in the USSR, it has tended to take the form that market activity took in the past: personal ties and income hidden from the government.

Mutual consistency has also been a problem. When a comprehensive reform package of 1987 was passed, a major investment was made in establishing consistency. After these laws were drafted, over 1,200 previous all-union decrees were declared defunct, along with about 7,500 republican-level decrees, and over 33,000 all-union and 800,000 republican ministerial rules and regulations. Subsequent laws and reform programs have appeared on at least a yearly basis, however, and have not been accompanied by such attention to the consistency of rules, regulations, and local laws. Now, as the regional disintegration of the Soviet economy has reached serious proportions, contradictory laws and regulations have become the rule rather than the exception. The rejection of central law has become a deliberate act of defiance in some of the republics, including Russia. All of this has led to a situation where, in the recent words of a Soviet journalist, "Today the people have become absolutely convinced that new Soviet laws do not operate."

All in all, the Soviet leadership has made essentially no progress in establishing economic legality, which is a prerequisite for creating incentive that could support a healthy market. On the contrary, as the continual policy reversals and economic decline of recent years have undermined the credibility of the leadership, it may be that the reform movement in the USSR has actually moved farther away from the institutional prerequisites necessary to support a market economy.