TAX ADMINISTRATION REFORM

IN TRANSITION: THE CASE OF CROATIA

Katarina Ott

Occasional Paper No. 5

April 1998

Institute of Public Finance

Katančićeva 5, 10000 Zagreb
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© Institute of Public Finance 1998
 TAX ADMINISTRATION REFORM IN TRANSITION:
THE CASE OF CROATIA

Katarina Ott

This Occasional Paper reports the research results of a project on the tax
administration in Croatia conducted by the Institute of Public Finance in Zagreb for
the Croatian Tax Administration. The project team report was finalised in summer
1997 and it includes ten papers which are published in Croatian in the Institute’s
journal “Financijska praksa”, Volume 22 , Number 1-2 (April 1998). This paper is the
summary of the project written by Katarina Ott (Institute of Public Finance).
 TAX ADMINISTRATION REFORM IN TRANSITION:
THE CASE OF CROATIA

Katarina Ott

ABSTRACT

The paper discusses the basic issues of modern public administration in general
and tax administration in particular, trends in their development and reforms in
tax administrations. The main weight in reforms concerns problems of
prevention of tax evasion, measures for making tax administration more
efficient and reducing the complexity of taxation laws. Special attention is paid
to tax administrations in transition countries with an emphasis on public
officials, ″ big state″″ , revenue collection problems and tax administration
reforms. Particular problem of running the state in small countries is also
discussed.

It can be concluded that modern tax administrations are concerned with a

stronger focus on taxpayers, specialisation of personnel, independence from the
ministries of finance and privatisation of those areas which could be better
performed by the private sector. In order to accomplish the above mentioned
goals, many countries have set in motion tax administrations reforms aimed at
solving some of the key problems such as low salaries and the connected problem
of attracting high quality personnel, corruption among tax administration
personnel and complex and incomprehensible tax laws. Most reforms stress
functional organisation of tax administration, organising a special customer
service units and separate departments to deal with the largest enterprises. This
should also reduce tax revenue collection costs and help to prevent tax evasion.

The extent to which Croatia, as a transition country, a small country and a

country carrying out reform of its fiscal system (including tax administration
reform), fits in with the processes described above is discussed in detail.
Suggestions for further improvement of tax administration in Croatia are also
given.
 TAX ADMINISTRATION REFORM IN TRANSITION: THE CASE OF CROATIA

The Republic of Croatia is currently engaged in reform of the overall fiscal system,
including the tax administration reform. This paper analyses the extent to which reform in
Croatian tax administration is in line with the theory and practice of tax administration in
developed countries and countries in transition.

I. Modern Public and Tax Administration

Modern democratic societies need a modern, democratic public administration which will
satisfy the public′s requirements in the best possible manner. Public administration must
continually undergo change and adjustment if it is to satisfy two opposite requirements. On
one hand, it must be effective and efficient, which is achieved by implementing the same
methods used in modern company management. On the other, it must satisfy the democratic
requirements, fairness and justice and defend the achievements of civilisation.

In these two endeavours, the former is predictably more appealing to economists,

especially American economists, while the latter is more attractive to lawyers, especially
European lawyers. It seems that, at least for the time being, the former stream is more
influential both in theory and in practice. The issues concerning tax administration are
discussed in, for example. Jenkins (1994), Andic (1994), Tanzi and Pellechio (1995). The
two prevailing streams mentioned above will not be discussed in this paper, in spite of
their significance, because this subject is very well analysed in Koprić (1997*).

Public administration in modern societies offers services to citizens and in the process
becomes more and more specialised. The time has gone when public servants had a general
training and were capable of working in any area of public administration, and when their
transfer from ministry to ministry was easy and painless. Speaking specifically of tax
administration, Jenkins (1994) points out that it more closely resembles an institution for
financial services than other public administration departments in charge of, for example,
education or health service.

Tax administration must collect revenues in accordance with the law and, at the same time,
provide an optimum public service. It must also pay attention to the administrative and
compliance costs of taxation. In an attempt to meet these requirements, tax administrations
are resorting more and more often to the implementation of principles and methods used in
running a modern company. The notion that no tax reform can be successful without
successful tax administration is becoming increasingly obvious, with the result that
governments are starting to pay special attention to the improvements of tax
administration.

The structure of tax administration must comply with relevant laws. An aspect that has
lately become increasingly prominent is the need for greater independence and
privatisation in tax administration. Independence of tax administration can be achieved by
making tax administration financially and administratively independent of the ministry of
finance, following the example of the central bank. In respect of privatisation, only those
jobs within the administration are privatised which are held to be better performed by the
private sector. The final goal is to offer a better service both to the state and to taxpayers.
The advantages and defects of this approach are discussed in Koprić (1997*).

II. Trends in Tax Administration

As was outlined above, the general trends in reforms of tax administration are towards
independence and professionalisation. (More on the issue, which will be only shortly
outlined here, in Jenkins, 1994).

Tax administration is usually a part of public administration. Due to budget restrictions,

those employed in public administration regularly earn less than those in the private sector.
Low salaries can neither attract nor keep the high quality personnel. This is offset by the
ability of some individuals to achieve compensation for their ″services″ or their ability of
attaining information in their work in the public sector which may later be useful in the
private sector. All forms of public administration offer the same opportunities, but
nowhere to the extent as in tax administration.

This results in a rather widespread opinion among the public that tax administration is
inefficient, incapable and corruptive. Once such opinion has taken roots, the tendency is to
cut salaries even more, which leaves those employed even further behind the salaries
received by the private sector. Governments are often fully aware of these circumstances
and respond by turning a blind eye to a system of unofficial payments which allows tax
administration to survive. This further decreases public revenue and increases costs for
taxpayers who have to bear the additional burden of these non-formal outlays.

This results in a highly dangerous situation in which the public come to doubt the integrity
and efficacy of the personnel, which directly influences their readiness to willingly pay
taxes. The government′s primary task should therefore be to reverse the process and make
tax administration a professional organisation offering good salaries and attracting people.
The administrative bodies of tax administration are often compared to central banks. But
central banks are usually more efficient than tax administration. Young people prefer
working for the central bank, the salaries are higher, the possibilities of advancement
better, the equipment superior and more sophisticated, work conditions are better, etc. All
these are reasons for the establishment of tax administration bodies independent of
ministries of finance. This would encourage professionality or, more precisely (1) the
rewarding and promotion of employees according to the responsibility of their job and
their success in performing it; (2) a job classification system which clearly defines the
responsibilities of each position; (3) independence from political influence and pressure
enabling people to retain their jobs long enough to pay back their education; (4) setting up
minimal conditions for each position and objective testing and (5) continuous education
modified according and adjusted to the needs of each individual job position.

III. Tax Administration Reforms

During the last twenty years, tax system reforms have been carried out in almost all
countries of the world. Reforms of tax administrations have been part of this more general
reforms and improvements in administration have turned out to be among the most
successful. (For details see Ott 1996).

Functions of tax administration

According to Tanzi and Pellechio (1995) the main tasks of tax administration involve: (1)
information and instruction to taxpayers, (2) registration, organising and processing tax
returns (input of data, processing declarations and payments), (3) coercive collection
(closely connected with registration, accounting and return processing), (4) control and
supervision (discovering lacking and insufficient tax returns and controls of books and
papers in tax administration offices or business activities and books of taxpayers, while
routine check-ups had already been done in the registration, accounting and return
processing department), (5) legal services and complaints (taking cases to court, defending
tax administration in court, explaining procedures which are or are not in accordance with
the law).
Inclination towards functional organisation of tax administration definitely prevails in
modern theory and practice. This means introducing more specialised activities which give
far better support to self-assessment of the taxation system. Tax administration develops
around activities (such as calculation or supervision and control) and not according to the
type of taxes or taxpayers. The main goal is to find the non-compliant. The majority of
employees deals with exceptions and control and supervision of tax compliance. Such
organisation requires self-control among personnel because working in one function serves
to control the other.

Andic (1994) points out the following advantages of the functional organisation of tax
administration:

(1) Productivity increases due to specialisation in particular fields like assessment,

collection, supervision and control, coercive collection, etc. An officer does not have
to know all the tax laws, or be responsible for tax assessment of the whole array of
taxes relevant for a certain group of taxpayers in his competence. Special departments
with specially trained personnel deal with new taxes, increased number of taxpayers,
etc. Routine jobs can be performed by lower rank personnel, while specialists can
concentrate on more complex tasks.

(2) Possibilities for checking and control are better. When the same tax officer is not in
charge of processing all the tax elements of one taxpayer, any mistake made in one
function (for example, tax assessment) will be more probably discovered in another
(such as, for example, control).

(3) Effectiveness of operation increases. If a taxpayer, for example, does not comply with
more than one type of tax, all taxes will be collected by one tax officer and not more of
them.

Complexity of tax laws influences tax administration

Complexity is one of the main problems of modern tax systems (Owens and Whitehouse
1996). Tax laws are composed in such an awkward manner that taxpayers can hardly
understand them and tax administrations have a hard time implementing them. This entails
more and more complex forms of tax evasion, causing increased costs of tax collection for
the state and increased compliance costs for taxpayers. More sophisticated tax evasion, on
its part, also influences the complexity of the system since it entails more detailed
legislature to cover all the holes in the laws. In Great Britain, for example, total
administrative and compliance costs of taxation amount to about 1.5 per cent of GDP, with
two thirds of the amount being at the expense of taxpayers (Sanford 1995).
Taxation laws in the USA increased 200 per cent in the period from the ′50s to the ′90s
(Owens and Whitehouse 1996). In 1979, as many as 90 mil. taxpayers filled in their tax
returns (as compared to 84 mil people voting in 1980) (Bawly 1982). Canada has trebled its
taxation laws in the ′90s with regard to the ′70s and the Netherlands has doubled its.
France is the only OECD country with the same number of taxation laws in the ′90s as in
the ′60s.

Australia, Ireland and New Zealand have all initiated programmes for improvement of tax
laws in order to reduce the compliance costs. The increase in tax administration is also
influenced by the increase in tax burden (from 25 per cent in 1965 to 40 per cent in 1994 in
the OECD countries), widening of tax base and increased contributions for social security
(Owens and Whitehouse 1996).

Tax evasion is not always deliberate. According to the report of Cato Institute 1995, the
majority of 40 mil. Americans ″in direct conflict″ with tax administration are simply
confused by the complexity of tax return (***1996). The resentment towards taxation is so
strong in the USA that a political party of taxpayers has almost nominated a famous
Republican Pat Buchanan as its President candidate in the elections.

Basic elements of tax administration reform

Considering the basic elements of tax administration reform, Tanzi and Pellechio (1995)
note the following requirements:

1. Firm and continuous political commitment. The process of reforming tax administration
takes time and requires political support on the highest levels. Argentine President
Menem and Minister Cavallo, for example, directly expressed their political support
for tax reforms, which were initiated by tax administration personnel.

2. A staff capable of concentrated work over a long period. Ministers of finance cannot be
daily involved in issues and problems arising from tax reform. They must delegate to
specialists strategy planning, setting time limits for implementation, monitoring daily
events, and decisions concerning transfer to less important jobs of personnel untrained
for proposed changes and dismissal of any involved in corruption.

3. A well defined and appropriate strategy. No strategy is suitable for all countries.
Reform of tax administration must adjust to local requirements such as a country′s
legal tradition in taxation system, local traditions, available personnel and resources.
Copying foreign practice is a bad policy if insufficient attention is paid to one′s own
circumstances. The strategy chosen may be gradual or sudden, but it must definitely be
 simple and flexible, allowing deviations in case of unforeseen event. It must also set
forth priorities and dead-lines.

4. Personnel training and education. Money is often spend in vain on extensive training.
Instead of attempting to gain wide and general education, it would be wise to narrow it
down to precise specialist qualifications.

5. Adequate funds for tax administration or at least transfer of people and resources. This
involves firing and hiring, adequate and differentiated salaries, and shifting employees
from low to high productive jobs. Tax administration can in this respect be regarded
like a business which must maximise production, i.e. tax collection. The tax
administration bodies must switch their organisation from being based on different
types of taxes and taxpayers to being based on the key functions of tax administration.

6. Change in motivation of taxpayers and tax administration. A great deal of relevant

literature deals with providing proper incentives for taxpayers. On the other hand, there
is almost no literature at all concerned with incentives for tax administration personnel
(motivating their effectiveness, rewarding honesty through higher salaries and
promotion or submitting them to penalties and dismissal).

Main tasks of tax administration reform

The two main tasks of any tax administration reform are achieving higher effectiveness
(capability to achieve high level of tax compliance) and efficiency (capability to make
administrative costs per unit of tax revenue as small as possible). The goal is to co-
ordinate effectiveness and efficiency because they can sometimes be contradictory. It
would be highly useful, therefore, to point out special measures for the improvement of
effectiveness and efficiency of tax administration

(1) Improving effectiveness

1. Voluntary tax compliance. The tax administration must acquaint taxpayers with various
procedures for reducing the costs of tax compliance.

2. Principles of self-assessment and self-payment. These principles make effective tax

administration and collection possible with a relatively small number of tax officers
who have to cover a large number of taxpayers.
3. Informing taxpayers. Tax administration must provide taxpayers with simple forms and
clear and short information on tax returns. This is specially important when new laws
are introduced (such as, for example, value added tax), when significant resources, and
the time of senior public officials, must be invested in explaining taxes and tax
liabilities.

4. Quick discovery of problems connected with tax returns and payment. It is extremely
important to discover taxpayers who have not filed tax returns, who miscalculated their
taxes or were late in paying tax. Tax administration must make sure that appropriate
steps are taken in such cases. If there seems to be too many unregistered taxpayers, an
investigation should be started. Tax inspectors could go from door to door checking
shops, handicrafts workshops, etc. for proper registration. They could also check
records of registered taxpayers to discover suppliers and buyers who are not registered
as taxpayers.

5. Improvement in control and supervision. Taxpayers can evade taxes in ways which are
difficult to discover. Thus more efficient control and supervision should be introduced.
It is highly important that taxpayers believe that tax administration has complete
control over everybody, including even the ″biggest fishes″. This will further stimulate
their tax compliance. It should be suggested that inspection covers a far wider scope
than it actually does. The programme must not be public and various circumstances
may be given as reasons that might trigger control mechanism. The control and
supervision programme, however, must clearly define subjects, time and the extent to
which control and supervision will go.

6. Appropriate penalties. Contrary to the opinion that higher penalties entail less control,
caution should be exercised here and penalties and control should be well co-ordinated.
Too high penalties entail, among other things, an inclination towards bribing tax
officers. It is therefore deemed wiser to use lower, but visible penalties, such as
closing shops, workshops or coffee shops for a few days or weeks than to charge high
penalties.

(2) Improving efficiency

Efficiency in tax administration is particularly stimulated by (1) establishing specials units

for the largest enterprises, (2) defining the minimum threshold for certain taxes (like, for
example, VAT), (3) alternate taxation for small taxpayers (annual payment, lumpsum
taxation or tax assessment on purchases), (4) taxation at source, (5) using bank services for
tax collection, etc.
Of the above mentioned measures, the possibility of establishing special units for the
largest enterprises should be specially emphasised. This unit should consist of leading
experts in the field (highly professional and screened for corruption). It should control tax
collection from the largest enterprises, which are small in number but nevertheless
contribute the major part (sometimes more than 90 per cent) of VAT and profit tax. The
largest enterprises also contribute a significant amount of income tax paid by their
employees.

This special unit would guarantee timely collection of the greater part of tax revenue and
also quick detection of unregistered and non-paid taxes, which would allow fast action and
proper measures. It might also serve to redirect initial efforts in tax reform and introduce
more effective procedures for the most important taxpayers instead of dealing with a large
number of small taxpayers which bring small revenue. Several countries have conducted
researches where new elements in tax administration were tested on such units, aimed at
proving to bureaucrats who resisted change that improvements indeed were possible. New
methods can later spread to other units of tax administration. Argentina, for example,
started with the unit covering 1,000 of the biggest taxpayers at first to end up today
monitoring about 200,000 taxpayers.

A special unit for the largest enterprises usually includes both tax collection and
supervision. Supervision is of special importance here because large enterprises perform a
great number of transactions, have complex business operations, a number of
organisational units (sometimes even in foreign countries), highly educated and
experienced accountants and lawyers, all of which enables them to resort to forms of tax
evasion which are difficult to discover. For the same reason, they also require a special
control unit consisting of highly professional and capable personnel. Dos Santos (in Tanzi
and Pellechio, 1995) cites 26 countries with special units for largest enterprises, 17 of
which are in charge of both supervision and collection, 1 of collection only and 8 of
control and supervision only.

Special problem of tax evasion

The main aim of tax reform is to collect as high a revenue as possible. In order to achieve
this, additional investment in tax administration and better prevention of tax evasion are
essential.

It is not always easy to connect investment in tax administration with the effects achieved.
As pointed out by Sanford (1997), expenditure on various customer service units, for
example, may increase the costs of tax administration in the short run, but nevertheless
reduce them in the long run. The calculation behind this approach is that a greater number
of taxpayers can be expected to hand in properly completed tax returns if they can get
advice and help. This investment can thus be regarded as the means for increasing revenue
because taxpayers′ opinion of tax administration will improve and they will comply with
their tax liability more willingly. Additional investments in the service of coercive
collection or supervision and control, on the other hand, can show their true face in a very
short time.

About 800 mil. pounds was spent on the action Spend to Save in Great Britain in 1996. The
greater part of the sum was earmarked for the prevention of tax evasion, but it is expected
that about 200 mil pounds invested in tax revenue office will in the next three years bring
back three times as much (with a thousand new inspectors and an additional thousand
transferred from other jobs where they had become redundant due to computerisation). It is
also expected that additional money in Customs and Excise will provide the same or even
better results. It is obvious that investments in tax administration increase revenue
collection, particularly if accompanied by an improvement in the effectiveness of control
and supervision.

Concerning tax evasion, Sanford (1997) points out that it is particularly important to
reduce possibilities for tax evasion and the net profit gained by it, and stimulate voluntary
tax compliance:

(1) Reducing possibilities for tax evasion

(a) Collecting taxes at source (on salaries, dividends, interest) is the best solution. If that
is not possible, a system of financial reporting should be devised which can be
compared with tax declarations.

(b) The tax system should have as few exemptions, allowances and deductions as possible.
Taxes should be elected which are more difficult to evade. Value added tax, for
example, with its in-built control mechanism, is an example. It should, however, not
have too many zero rates and different rates which again increase tax evasion
possibilities.

(c) Tax administration must be honest since a corrupt tax administration stimulates tax
evasion. This means a simple tax structure where tax officers have minimum
discretionary authority.

(d) Assigning a special tax number to each taxpayer has proved a to be very useful device.
Australia (where interest is taxable), for example, requires registration of one′s tax
 number for every newly opened savings account. If this is not done, banks
automatically deduct tax on interest at the highest rate. The same system is also in use
in Latvia, where every taxpayer must be registered with the State Revenue Office and
financial institutions are forbidden to open accounts either for individuals or
companies without taxpayer number (World Bank 1996).

(2) Reducing net profit gained by tax evasion

Net profit gained by tax evasion is reduced if the ratio between risk and profit increases.
To achieve this, control and supervision need to be intensified by giving maximum
publicity to tax evasion prevention, increasing fines and sentences, and publicising at least
figures if not names. Special attention should be paid to fines and sentences because
overstressing them may lead to the feeling of resentment of tax administration and tax
compliance.

(3) Reducing willingness to evade

Developing an increasing acceptance of taxation and tax administration, although slow,

will reduce willingness to evade. It will involve:

(a)The state must create conditions for just and fair elections, equal implementation of
laws for all, independence of courts, a cheap, quick and easily accessible system of
complaints for everybody, and strong feeling of citizens′ civic duty.

(b) Belief in the fairness of the system. Distrust of the government is very disruptive for
tax compliance. If the state is perceived to be corrupt and wasteful (expensive
buildings, cars, airplanes), if there is conviction that certain ethnic groups and
economic classes fare better than other people in the distribution of state funds and
that taxation is not sufficiently vertically or horizontally fair, etc., citizens are very
likely to stop believing in their state. All that calls for constant refutation. The state
must be seen to be just and fair. Lawbreaking and all violations must be punished
severely. The state should report to the public regularly and in detail about its
expenditures. Reducing costs of tax compliance is very important. The intention should
be made public and borne in mind in every discussion about taxation policy. Revenue
offices in Great Britain, New Zealand and Australia, for example, are obliged by law to
prepare preliminary assessments on how each proposed change in the law will reflect
upon the costs of tax compliance.
(c) Relationship with tax administration. Special customer services units and special small
business units are more and more founded within the tax administration. These services
are well aware of the needs and problems of their customers. Taxpayers are approached
as clients to be given assistance, innocent until proved guilty. Andic (1994) claims that
such special services for help, information and education increase taxpayers′s trust in
tax system. Moreover, it leads to reducing compliance costs and improving the level of
tax compliance. Information are not only given through the media, but in various
publications, by phone, and in person. Systematic, simple and understandable
literature on tax system, allowances, and detailed instructions on completing and filing
tax return are imperative, together with direct help provided in completing tax returns.
Sanford (1997) points out the special importance of an adequate complaints system. A
Citizen′s Charter Complaints Task Force was established in Great Britain in 1993. A
complaints system must be easily accessible, widely known to the public, easy to
understand and use, and quick in reaching timely decisions. It must also make clear to
individuals the state of their case, ensure complete fairness of investigation, honour the
principle of privacy, deal with all aspects of the problem, provide both answers and
help, and inform the management, enabling it to improve its services. A special
Adjudicator was appointed in Great Britain, first for the Inland Revenue and later on
also for the Customs and Excise, and Contributions Agency. The adjudicator is not
concerned with technical issues of taxation and tax compliance (which are in charge of
a special complaints system), but deals with complaints against administrative bodies
in revenue services.

In short, the most important preventive measures against tax evasion, according to
Sanford, involve taxation at source whenever possible, a simple taxation system with
minimum tax exemptions, an efficient supervision and control mechanism capable of
achieving maximum revenue, a regular check on penalisation (especially during inflation)
and adequate publicity in the case of stricter penalties, economical and fair public
expenditures, just taxes, and fair, client-friendly tax administration.

IV. Tax Administration in Transition Countries

Transition from a planned economy into a market one requires thorough examination of the
role the state plays. World Bank (1996) points out that the role of the state must
significantly decrease and the services offered by the state must become exceptions and not
the rule. States must direct their efforts to stimulating macroeconomic stability and
providing a legal and institutional environment stimulating the development of the private
sector and of competition. Reforms of fiscal systems are undertaken with this specific aim
in mind, meaning reforming or (in certain transition countries) only just introducing tax
administrations.

Transition countries have to chose between the more liberal American style market
economy and the more social market economy of Western Europe style. The issue boils
down to offering the citizens a broader or narrower range of free education, health care and
infrastructure or the choice between a greater or smaller degree of income redistribution.
But no matter which road they take, all transition countries must improve the effectiveness
and quality of their services and direct their efforts to achieving results put forward in
state programmes and their costs. An especially important mission of transition states is
education of the public on the need for and the process of reforms, including the reform of
the state itself, and making their policies and decisions as clear as possible. Achieving
agreement between politicians and as many citizens as possible on the need for reforms is
imperative. Reform of the state is carried out together with the liberalisation of its
economy. Some reforms can be accomplished quickly (like the withdrawal of the state from
production) and some require long-term institutional changes and lag behind market
liberalisation (like the improvement of tax administration).

Public officials in transition countries

The changed role and different running of the state involve changes in professional state
administration. The World Bank (1996) experts estimate that public officials in transition
countries are often concentrated in wrong public sectors. The state does not transfer its
officials quickly enough to suit the changes of its functions. Officials often have the wrong
education for jobs they perform, insufficient difference in salaries and other motivating
elements are equally non-stimulating. Contrary to the general opinion, most transition
countries do not have too many public officials, nor are they underpaid. Their distribution
is simply extremely irrational.

World Bank (1996) shows that the data on state employees and their salaries are, generally
speaking, in line with the same data in industrial countries. This means that there exists a
drop in real wages and a growing gap between the salaries in the private and public sector.
Especially alarming are the lack of employees and too low salaries in key areas such as
customs and tax administration and police. The problem lies in the distribution of
employees. Basic central and local administration bodies in transition countries are usually
very small, while education, health care and other public services have too many
employees. Usually, there are too few professionals and too many of other staff. Even
where the average educational level is high, civil servants do not have sufficient
accountancy, taxation, legal and other specialised knowledge about public administration
required for the market economy. In addition, salaries in the public sector are seriously
limited and effort and success at work hardly influence the amount earned or promotion
possibilities. Instead, personal and political connections are still overstressed in making a
career. It is therefore not surprising that public administration in many transition countries
is drowned in low morale, absence from work, moonlighting, corruption and the exodus of
the best workers into the private sector.

These problems cannot be solved overnight, but the direction of reforms is more than
obvious. Salaries, hiring, advancement and firing in the public sector must be more
flexible. Majority of privileges and payments in kind must be replaced by cash payments.
Differences in salaries also must increase significantly. As a special imperative in
transition countries, the state must de-politicise public services, introduce systematic
standards for professional advancement in career and condition it by the acquisition of
knowledge required in market economy. Employment of public officials must be carried out
in accordance with the law on public officials salaries and budget plans.

The problem of the ″big state″ in transition countries

Transition countries are particularly inclined to ″big states″ which are expensive and
difficult to finance. There is an attempt to solve the problem of insufficient state revenue
in most of these countries through the improvement of taxation policy, particularly tax
administration.

Reducing expenditures in states where public consumption is traditionally high and the
population expect a wide range of public services is exceptionally difficult. It is especially
dangerous that taxation itself is used for achieving various economic and social goals
which only produces additional pressures for tax exemptions and lowered tax rates. Special
problems present: tax collection from public companies which in fact have special deals
with the state and coverage of the growing small private sector inclined to tax evasion.

Tax revenue collection in transition countries

According to World Bank (1996) among special taxation distortions in transition countries
which can cause low revenue collection and complicate tax administration the following
should be pointed out:

1. Basic rates are often very high, which stimulates tax evasion and unofficial economy.
2. Dependency on income tax for financing social expenditures is too high. Income taxes
usually imposed upon employers can hinder entrepreneurship, discourage regular
employment and entail unofficial economy.

3. Numerous tax exemptions and different tax rates for various business activities.

Improvement of the tax revenue in transition countries requires reforms in tax structure
and the taxation system, and also in revenue collection. In this respect, restricting tax
exemptions and cancelling tax differences among the sectors is imperative. Value added
tax must be applied on all goods and services, except imports, which is taxed at zero rate.
Strategic goods like gas and oil must be taxed just like any other goods. Moreover,
significant excises can be introduced on them. Income and profit tax deductions must be
restricted in scope and agriculture ″taken care of″ (by eliminating tax exemptions first and
then by introducing land charges). The total amount of profit, income, wages and value
added taxes must be examined in order to improve tax efficacy and reduce tax evasion.

Effective tax administration in market economies is based on voluntary tax compliance by

a large number of decentralised taxpayers. Transition countries are now only just
beginning to pay attention to the importance of tax compliance and creating a modern tax
administration capable of better and more efficient tax collection. Functional organisation,
concentration on biggest enterprises and issuing tax numbers to taxpayers are highly
recommended in this respect.

Control and collection also must be improved. Control should be carried out selectively,
abandoning the principle of checking every taxpayer at regular intervals. Tax
administration in transition countries must also be given stronger competence in coercive
collection (ranging from sequestration to closing down companies).

V. Reform of Tax Administration in Transition Countries

Reform of tax administration in transition countries is usually carried out as a part of fiscal
system reform. Countless texts and discussions have been written on the problem of
forming institutions, property rights, transaction costs, etc., but hardly any practical
analyses exist on the organisational aspect of public finance. The majority of literature in
transition countries concerns policy and not organisation. Authors taking up organisational
issues are few and rare (Tanzi, Jenkins, Sanford).

Tax administration in transition countries is usually organised according to types of

taxpayers, taxes or economic sectors, which is exactly opposite from the usual approach in
contemporary theory and practice.
Andic (1994) points out that transition countries most definitely need changes in tax
administration, and its adjustment to modern accounting, control, assessment, collection,
coercive collection, compliant procedures and the growing number of individual taxpayers
and private companies. He perceives the reorganisation in issues like the position of tax
administration in the ministry of finance, internal organisation of tax administration and
the order of changes as being of primary importance.

Experts are not unanimous regarding the location of tax administration. Some favour the
approach that tax administration should be a part of the ministry of finance (for example,
Casanegra, Silvani, Vehorn), while others are in favour of the independent tax revenue
office with the status of ministry or body independent of ministry (Jenkins). Regardless of
the differences in this respect, all (including Tanzi) are in favour of an effective and
efficient tax administration.

Concerning internal reorganisation of tax administration, more or less everybody agree

that it should be based on the functional principle (Andic 1994, Tanzi and Pellechio,
1995).

As far as the order of changes is concerned, priorities in reorganisation must first be

established, such as the form of taxpayers registration, collection and accounting system,
introducing suitable tax return forms, discovering offenders, choosing subjects to be
controlled, employing new employees, their distribution into departments, location,
education, etc. Organising special customer service units is usually recommended to take
place in a relatively short time (six months), because this service, together with
appropriate training of old and new tax officers, is expected to show results in shortest
time possible.

Tax administration organisational change is expected to take a considerable time (up to

two years). It must be carried out gradually, with special attention to strengthening leading
capabilities on all levels.

Strengthening of tax administration will not result in higher revenue immediately, in the
short term, but these steps nevertheless must be taken. Priorities must be given to the
development of procedures for registration of taxpayers and tax return, to the process of
payment, control over tax compliance and organisation of adequate training of tax officers.
Increasing the level of information and education given to taxpayers is also very important,
which calls for organising special taxpayer relation services within tax administration.

Reorganisation of the existing tax administration along the functional lines is a long, time
consuming process which involves shifting employees into new departments, perceiving
needs for opening new jobs, starting adequate training, developing the system of leading
and internal control and planning computerisation. Organisation, however, can never be
final and it should be able constantly to change and adapt.

To sum up, in order to collect sufficient revenue for financing public needs transition
countries need to change the structure of tax administration, educate personnel and better
inform and instruct taxpayers.

VI. Specific Problems of Running the State in Small Countries

Having examined the theory and practice of tax administration in general and of tax
administration in transition countries in particular, it will be interesting to consider some
specific difficulties faced by small countries.

In his very interesting paper on how small countries are run, Harberger (1988) says that
their main problem is usually that they have too few trained and experienced people to run
the state properly. And he draws the line of a country qualifying to be a small country at a
population of 20 million!

According to Haberger, a country of 6 mil. inhabitants (like Croatia) will have less than
1.2 mil. inhabitants older than 40, and the number of the sufficiently educated will be less
than 1 per cent of these. This educated elite is supposed to run the state and to fill
positions of senior ministers, generals, colonels, judges and lawyers, accountants and
auditors, tax-collectors and teachers and, of course, engineers, agricultural workers, etc.

Since this enormous responsibility rests on the shoulders of such a small number of people,
the state should be as simple as possible (in its legal system, budget, taxation system, etc.).
Everything should be as simple as possible, with as few exceptions as possible, and the
usual trap of having administration with broad discretionary authorities must be avoided at
all costs.

Due to the small number of people, organisation of small countries must make the best
possible use of its human potentials. Policies must be simple, rules clear and easy to
implement. The state must be just, equal for all and impersonal.

This requirement conceals what is predominantly a demographic problem. It is easy to have

an impersonal state which implements rules in a big state. In small countries, however,
with the total ″elite″ members numbering only a few thousands, this is extremely hard to
achieve. The ruling class has family ties all over, many frequented the same schools, came
from the same regions, etc.

Tax inspectors in small countries will be daily pestered by enquiries about the tax status of
the members of their family, friends, schoolmates or relatives of their family and
schoolmates. It is no wander then that nepotism and corruption emerge. In such conditions,
people truly dedicated to reforms are more than likely to end up in total isolation. They
will offend their families and friends and become objects of ridicule and derision. They
could even lose their jobs and friends.

Solution to this problem is not simple. Small countries should develop a professional
attitude, and introduce reforms which take into account their objective circumstances and
do not attempt to introduce systems incompatible for the limited number of people to carry
them out.

VII. Tax Administration in Croatia

Having gone through tax administration in theory and practice of modern countries, with
special emphasis on transition countries and small countries, the following conclusions can
be reached:

The trend in modern tax administration is a strong focus on taxpayers, specialisation of

personnel, independence from the ministry of finance and privatisation of activities which
can be better performed by the private sector. In order to achieve the above mentioned
goals, many countries have started reform of tax administrations aimed at solving some
key problems, such as low salaries and resulting difficulties in attracting high quality
personnel, corruption among the employees and complex and incomprehensible taxation
laws. The majority of reforms stress functional organisation of tax administration,
organising special public advice services, separate service for the largest enterprises,
reducing costs of tax revenue collection and prevention of tax evasion.

To what extent does Croatia, as a small and transition country carrying out reform of fiscal
system, including tax reform, fit into the processes described above?

If we read Croatian Law on Tax Administration carefully and compare it with similar laws
in other countries and with basic recommendation of world experts, we must conclude that
the Croatian Law repeats more or less all that is said in other laws and recommendations of
relevant experts. Whether or not the comparison of Croatian practice and the practice of
other countries would yield the same result, it is hard to say just now. One of the basic
problems the Croatian taxpayer has to face is the fact that tax officers do not follow the
laws all the time, but also resort to various rules and regulations, instructions and
explanations which may, and just as easily may not, correspond fully with what is said in
the law.

(1) Focusing on taxpayers

It is difficult to estimate the extent to which in practice the Croatian tax administration is
focused on taxpayers, which is one of the elementary conditions of its effectiveness and
efficiency. Such focusing is not indicated at all in the Law on Tax Administration. The
only point that might suggest anything that could be considered as taxpayer friendly
behaviour is Article 3, Paragraph 11 of the Law. It says that Tax Administration ″is
concerned with the development and improvement of the tax system.″ Concern about
revenue collection and repressive action towards taxpayers are the only visible and
predominant topics throughout the whole Law, with not a single reference to taxpayers
being perceived as beneficiaries and without any reference to their rights. Zhe Law
constantly mentiones only taxpayers duties. Analysis of Tax Administration jobs (Koprić
1997*) also shows that relations with taxpayers are hardly ever mentioned.

In its further development, the Croatian Tax Administration should, therefore, pay special
attention to the following: (1) requiring in an official act polite and prompt communication
of Tax Administration officers with taxpayers, (2) during the study Course in Taxation,
special attention must be paid to educating students in the spirit of democratic principles
and good relations with the public, and (3) organising special customer service unit at least
on the level of the Central Tax Administration Office.

(2) Specialised training for tax administration officers

Croatian Tax Administration have inaugurated special Tax studies at the Zagreb Faculty of
Law. In addition, specialisation have been conducted within the Tax Administration Office.
Obviously, it is more important to improve the quality and expertise of employees than to
enlarge their number. Following this line, Brčić and Jančiev (1997*) argue in favour of
employing more personnel with graduate education and fewer with undergraduate
qualifications only. It is difficult to say whether this is in accordance with the modern
perception of the need for constantly greater specialisation of tax officers. Perhaps
secondary (high) school qualifications might suffice for the majority of jobs in tax
administration, with specialisation only for particular kinds of job. Arbutina (1997*)
points out that Tax Administration should reduce the number of economists employed and
increase the number of lawyers, which seems logical enough. Economists should
predominate in drawing up and running the tax system. Lawyers should predominate in
drafting laws, and controlling obeyance of regulations, dealing with complaints, etc.

Bearing in mind what has been said about specialisation, the following may be
recommended: (1) institution of postgraduate studies in public finances, (2) continuous in-
service training of tax officers, but not necessarily an increase in numbers, (3)
fundamental, frequent and constant specialist education carried out separately for each
type of job, (4) paying special attention to predominantly economic or legal education of
personnel when employing new tax officers or shifting them to other jobs, depending on
the requirements of the job in question.

(3) Tax administration independence

The issue of independence of the tax administration of/from the ministry of finance is not
only of technical, but also of political nature. Croatian Tax Administration is neither
independent, nor particularly autonomous. It is a part of the Ministry of Finance, does not
have the status of legal body and is financed from the budget. Brčić and Jančiev (1997*)
consider that it is not detrimental for Tax Administration to be part of the Ministry of
Finance because this makes its co-operation easier with the Financial Police, Customs, etc.
Financial dependence on the budget, however, causes considerable problems for tax
administration. The salaries of its employees are restricted by the budget, which makes it
difficult to attract and keep high quality experts and impossible to stimulate adequately
their better performance at work.

Although modern literature is increasingly in favour of tax administration independence

and its organisation on the same principles as independent central banks, this approach
would be difficult to recommend for Croatia at this moment. Any more significant
independence granted to tax administration would entail a higher level of democratisation
in political system, with explicit mechanisms of democratic control which would prevent
possibilities of making tax administration an instrument in the hands of political elite (see
Koprić 1997* and Arbutina 1997*). The best recommendation, then, would be to leave the
Tax Administration as a department within the Ministry of Finance for the time being, but
also to continue developing its independence within the Ministry and, as Brčić and Jančiev
(1997*) suggest, to let it keep a certain percentage of the tax collected. It would then be
able to use its own funds for salaries and other stimulation at work or for investment in
additional education and specialisation.
(4) Privatisation of certain areas in tax administration

Economic privatisation in Croatia has not yet gone very far. Not even big public companies
have been privatised, let alone public administration, which is practically not even
seriously considered yet. Croatian Tax Administration, however, could start thinking (as
many tax administrations in other countries already have done) about the possibility of
privatisation of certain of its activities which would be better performed by the public
sector. Jurlina-Alibegović (1997*) points out the possibilities for privatisation in computer
services, issuing and sending tax forms and reports on paid taxes, gathering, sending and
filing in documents, correspondence with taxpayers, etc. Koprić (1997*), however, is more
sceptical and warns against excessive privatisation which could work at the expense of
citizens. Although privatisation is inevitable in the long run, Tax Administration should
not be let slip back to tax farming, which would be a serious political and civic step
backwards.

(5) Low salaries in tax administration

Tax administrations in almost all countries are faced with the restrictions arising from
budget funds. Tax administration officers as a rule have low salaries, often significantly
lower than the private sector. Due to this problem, tax administrations have a hard time in
attracting highly educated and good workers. Croatia is no exception in this respect.
Average salaries of tax officers lag behind salaries in the private sector. According to the
level of salaries, Tax Administration occupies fifth place (among the organisations for
which data are available), behind the inland service of the Ministry of Foreign Affairs, the
Customs Office, the Ministry of Economy and the Ministry of Development and
Reconstruction (see Koprić 1997*). There have recently been more and more requests that
something should be done about the salaries because of the important role Tax
Administration plays in revenue collection and thus in financing the state. Tax officers can
be stimulated through higher salaries, further education, career prospects and impartiality
in hiring (Arbutina 1997*), keeping a part of revenue collected which could be used for
salaries, motivation at work and education (Brčić and Jančiev, 1997*) or through
establishing a special fund for rewarding employees according to the results achieved
(Bejaković 1997*).

(6) Corruption among tax administration officers

Low salaries in public administration, and especially in tax administration where officers
have high discretionary authority is frequently a source and cause of corruption. This
phenomenon is supposed to exist, but difficult to discover or prove. The public is usually
very well tuned to listening to any such rumours and quick to draw conclusions on the
quality of public administration. Public opinion plays an important role in forming
acceptance of or aversion towards proper tax compliance. Croatia certainly is no exception
in this respect. Štulhofer (1997) claims that as many as 75 per cent of respondents in a
representative Croatian sample believe that all or almost all public servants are corrupt.
Although this refers to all public servants and not only Tax Administration, and even
though it need not be based on real facts, it should be constantly kept in mind. In order to
prevent corruption and invalidate rumours about possible corruption, Tax Administration
bodies should: (1) eliminate the high discretionary authority its officers have, (2) organise
jobs along functional lines which allows transparency, (3) severely punish any irregularity
in the work of its personnel, (4) do its best to improve the opinion of the public (through,
for example, establishing customers service unit.

(7) Complex and incomprehensible tax laws

Complex and incomprehensible tax laws have been an increasing disease of modern
taxation systems. Although one of the basic criteria in Croatian tax reform was simplicity
(Rose and Wiswesser 1995), the new system is still rather complex, vague and imprecise
(more about this in Ott 1996a). Arbutina (1997*) shows that in solving everyday problems
of implementation of the new Croatian tax system, two specific institutions have emerged:
the institution of opinions of the minister of finance and the institution of the Ministry of
Finance rulings. Opinions of the minister result in inconsistency and violate legal safety.
Rulings have in time turned into what they should not have been - an additional source of
law which now violates legal safety and directly threatens legality. Koprić (1997*) points
out that the Decree on the Internal Organisation of the Ministry of Finance has widened the
range of Tax Administration activities by giving the minister of finance authority to
expand jobs within the Tax Administration competence. The Central Tax Administration
Office also passes implementation rules which are not in accordance with the Law on State
Administration System. Doubtful solutions should, therefore, be examined and the
institutions of advance ruling or letter ruling might be introduced as instruments of
improving implementation of new rules and regulations.
(8) Functional organisation

Functional organisation is favoured not only by foreign experts, but also by many Croatian
ones (like Bejaković, Brčić and Jančiev, Jurlina-Alibegović, etc.). It is difficult to estimate
whether Croatian Tax Administration is already organised, as some claim (Brčić and
Jančiev 1997), on the functionality principle. The Central Office of Croatian Tax
Administration is to a certain extent organised along the functional lines (especially its
services for normative activity, administration procedure, control, etc.). When these
services are divided in departments, however, this ceases to be functionality principle and
becomes simple division of various taxes into appropriate departments. In local tax offices,
jobs are divided among departments by the type of taxes and the number of taxpayers. In
the Zagreb local tax office, however, functional departments have been organised (for
assessing and monitoring taxes, reclamation and coercive collection, and control and
supervision).

One of the reasons justifying the functionality principle is that it allows tax administration
to primarily concentrate on (besides self-assessment) exceptions and controlling tax
compliance. Tax Administration in Croatia seems, however, to be primarily engaged in the
activities the taxpayers should be doing themselves. Brčić and Jančiev (1997*) claim that
as many as 46.2 per cent of tax officers are engaged in tax assessment. Only 19.5 per cent
of them are engaged in control activities in Croatia, even though the majority of tax
officers should, in the normal course of taxation, be engaged in these activities. The results
are even worse and more depressive if we look at the number of functions. Koprić (1997*),
acknowledging but not taking into account the Financial Police, points out that only 9 per
cent of all Croatian Tax Administration functions involve control functions.

Further possibilities for specialisation of jobs and services along the functional lines on all
levels of Tax Administration should be investigated in more detail. The aim of the
functionality principle in organisation is improvement in productivity, effectiveness,
inspection and control.

(9) Establishing special customer service unit

It would not be fair to say that Croatian Tax Administration does anything but its best to
keep taxpayers informed and instructed. When occasions dictate, taxpayers are informed
about changes in the taxation system, deadlines, etc. through radio and television
broadcasts and newspapers. In addition, departments for tax assessment and monitoring in
regional offices are required to provide taxpayers with professional help and answer their
inquiries. But, the modern practice of focusing on taxpayers has given rise to special
customer service unit. This service should be for starter established at least in the Central
Office and then at other levels as well. Its task would be to give as simple instructions as
possible about the filling in and filing tax returns. Its aim would be improving public
relations, increasing confidence and trust in taxation system and tax administration
activities, reducing compliance costs and make the whole procedure simpler and easier.

(10) Establishing special service for the largest enterprises

The practice of other countries has shown that establishing special service for the largest
enterprises can achieve excellent results in collection and inspection of taxpayers who
bring in the major part of revenue. Such service is favoured also by some Croatian authors
(for example, Brčić and Jančiev, Jurlina-Alibegović). It should first be organised in the
Central Office and then at other levels of tax administration. It should bring together the
most capable and experienced officers who should be well paid in order to avert the
temptation of bribery. The results of control and supervision of few top taxpayers and
beneficiaries should be bound to become visible very soon.

(11) Decreasing tax collection costs

Focus on taxpayers, reducing tax evasion, increasing tax administration effectiveness and
efficacy must be accompanied by a precise and detailed knowledge of both compliance and
administrative costs. The majority of developed countries try their best to reduce these
costs, increasingly due to the complexity of taxation systems, to some reasonable,
acceptable level.

No precise calculation of these costs exist in Croatia as yet. Brčić and Jančiev (1997*)
have roughly estimated taxation costs to be HRK 6.6 in 1994. 9.2 in 1995, and HRK 9.7 in
1996 at every HRK 1,000 of tax collected. The costs have been increasing, especially in
1995 with regard to 1994. The rise coincides, however, with employment of new tax
officers and introduction of new taxes. The average costs during the last three years were
HRK 8.6 at every HRK 1,000 collected. Without further evaluation and comparisons with
other countries, however, it is difficult to say whether such costs are high or low.

Kraft (1997*) therefore suggests further detailed investigation of compliance costs in

Croatia. It is imperative to estimate the costs of (1) general sales tax which brings in the
major part of budget revenue, (2) income tax which is the second important, and (3) to
compare the costs of sales tax compliance with the same kind of costs in VAT. Carefully
conceived and appropriate research could reduce the tax burden and even improve the
public perception of tax administration. Research can well be expected to reveal too high a
burden on tax authorities and an insufficient burden on taxpayers with regard to other
countries where tax administrations were reduced and who make use of more tax
exemptions than Croatia.

(12) Prevention of tax evasion

Tax evasion has become major problem even in countries with the most developed tax
administrations and with the best of prevention mechanisms. Research on tax evasion in
Croatia (Madžarević 1997) indicates its alarmingly high extent and tendencies. Even more
alarming are socio-cultural aspects and the public attitude towards tax evasion (Štulhofer
1997). Since it is always more advisable to prevent the causes than to punish for the
consequences, Croatian tax administration would be well advised to, together with
everything said before, mind the following:

1. The taxation system should have as few exemptions, deductions and allowances as
possible. This should be paid special attention in introducing value added tax, and
passing special laws on certain categories of the public, regions, industries, etc. (i.e.
liberated territories, islands, disabled persons, free-lance artists).

2. As efficient control and supervision system as possible is necessary, especially of the

largest enterprises, along with the institution of special units for large enterprises if
possible.

3. The penalty system must be regularly examined and adequate publicity given to any
penalty increase. Since tax evasion in Croatia makes reputation of evaders better and
not worse (Štulhofer 1997), too much should not be expected from disgracing tax
evaders. A better solution might be punishing the really biggest perpetrators at the very
top of political power. This would also re-establish trust in the impartiality of political
institutions. Political motives should not be allowed to influence decisions here so that
there can be no accusation of political cleansing.

4. The Tax Administration should also do its best to influence cutting down any public
expenditure which may seem wasteful, unjustifiable or unfair.

5. The reputation and impartiality of the Tax Administration should be constantly

strengthened and so show its focus on taxpayers. Special public relation services
should be organised with this aim in mind.
6. Special ID taxpayer numbers are very useful in preventing tax evasion. Since such
numbers already exist in Croatia, co-ordination with courts of justice should be
improved with the aim of obliging them to send data to Tax Administration regularly.

7. Regular assessment and monitoring of tax evasion in all relevant taxes is necessary.

8. A socio-cultural analysis of tax evasion would also seem to be valuable and its results
should be compared with the results of the Tax Administration control and supervision
services.
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