Why then was the Estonian government toppled? Why, indeed, have left-wing parties, descendants of the former communist parties of the region, succeeded in winning elections in nearly every country of Central and Eastern Europe (with notable recent electoral triumphs in Bulgaria, Estonia, Hungary, Poland, Slovakia, and Slovenia)? The simple answer given by many critics of market reforms is that the reforms have been too cruel, or that the public yearns for the certainties of the past.

These explanations largely miss the point.

• Opinion surveys in Central and Eastern Europe repeatedly show that the public does not want to go back to the old regime, nor does it view the left-wing parties as instruments to undo the new market economy.

• The living standards of the population did not really drop, if one examines actual household consumption behavior (rather than changes in crude indexes of real wages, which do not give a picture of the shortages prevalent in the old regime). Indeed, in many countries including Estonia, the public is in the midst of a startling buildup of consumer durables—cars, refrigerators, videocassette recorders, and the like—that were long unavailable under the old regime.

In most countries of Eastern Europe, social spending has not only remained an unusually high proportion of GNP, it has actually soared. The postcommunist countries in Eastern Europe have among the most generous social welfare budgets in the world when measured as a percentage of GNP, especially when considering the level of development as measured by per capita income adjusted for purchasing power parity. Social spending budgets tend to be between 15 and 30 percent of GDP, in comparison with the outlays of East Asian countries at similar income levels, which average between 5 and 10 percent of GDP for similar social programs.

Escalating Social Spending

Ironically, it is the high and escalating social spending, not the alleged cuts, that offers us the real insight into the political dynamics of the region. Rather than seeing the Eastern European elections as great referenda on the market system, or on capitalism versus communism, or even as protest votes against harsh reforms, one can see that the elections in Eastern Europe have become almost exactly like elections in Western Europe and the United States: dominated by interest group politics.

Left-wing parties are winning the elections in Eastern Europe in part because they are seen by the organized recipients of state largesse as the parties most likely to maintain or increase the entitlements of the social welfare state. The former Estonian government may have been too severe in its pension policy, but at the same time, parties advocating moderate benefit levels have been defeated by parties willing to raise the stakes in populistic campaigns for the pensioner vote. Generally speaking, most East Europeans want both a market economy and the security of an extensive social safety net.

Social spending has increased significantly as a percentage of GDP in selected countries of Eastern Europe

(table 1). In Poland, whose supposedly "cold turkey" reforms have been alternately admired and reviled—but almost always believed to be harsh—social spending soared a remarkable 11 percentage points of GDP between 1989 and 1993. Sharp increases in social spending are also recorded in Bulgaria, Hungary, and Slovakia. In most countries the cuts in subsidies that accompanied price liberalization at the start of reforms were offset in part, or even in full, by increased social spending, rather than deficit reduction.

Social spending in Eastern Europe ranks high when seen in an international comparative perspective (table 2). The most recent comparative data are for 1985-90, taken from the United Nations World Development Handbook, 1994. Data for more recent years would likely show an even larger discrepancy between Eastern Europe's generous social spending and the much lower social spending in other parts of the developing world. The counterpart of Eastern Europe's heavy social spending is extremely high tax rates, particularly on labor, which distort the economies, reduce capital inflows, and raise unemployment rates, partly because of work shifting to the untaxed grey economy.

In addition to the politics of entitlements, the left-wing parties have also reaped the advantages of a fifty-year "head start" in organization, fund-raising, recruitment of activists, presence in the factories, trade unions, and bureaucracy, and other nuts and bolts of party organization. In most countries the communist parties were able to bequeath these assets to the political successor parties. An apparent exception is the Czech Republic, where the process of lustration (disqualification for state posts as a consequence of previous senior membership in the communist party or secret police) dramatically weakened the communist party organization.

There are three special reasons for the enormous electoral power of the pensioners and other recipients of state aid in the postcommunist states of Eastern Europe and the former Soviet Union.

• First, the communist regimes were characterized by universal and extensive entitlements, partly as the result of socialist ideology, and partly as the result of political competition with the West. The Soviet Union and its dependent states in Central and Eastern Europe made lavish commitments of lifetime job tenure, universal pensions, generous (and widely abused) disability systems, guaranteed education, vacations, health, housing, and the like. Of course, these promises could not be fulfilled, and governments throughout the region went bankrupt as a result of these excessive commitments. Nonetheless, as we know from Western politics in countries as diverse as the United States, Sweden, Greece, Italy, and elsewhere, entitlements are almost impossible to reverse even in the face of extreme budgetary pressures.

• Second, because of low population growth rates, the East European populations are relatively old, with high dependency ratios compared with populations in most developing countries at similar income levels. This adds an extra burden on state pension costs.

• And third, among all of the age groups in the postcommunist societies, the adult populations over the age of 45 have had the hardest time adjusting to the new market conditions. For older workers, mobility costs tend to be very high, retraining tends to be difficult, and the time horizon for market returns to retraining tends to be short. Therefore, politicians and reformers have opted to "buy out" this age cohort through generous arrangements for early retirement, often starting at ages 45 to 50, and through lax standards for disability pensions.

The result is an extraordinarily large proportion of the adult population covered by pensions, as illustrated in table 3 for Poland. Roughly one-third (32 percent) of the entire Polish adult population is covered by pensions (with an astounding 9 percent of the adult population on disability pensions), compared with pensioners accounting for roughly one-fifth of the U.S. adult population (21 percent). The number of Polish pensioners increased by some 28 percent in just four years, from 1989 to 1993, while the overall population increase was just 1.5 percent.

In several countries, farmers are probably the second most vocal political pressure group besides pensioners. Agrarian parties have formed coalitions in many of the postcommunist countries. At the outset of market reforms, the agrarian interests suffered relative income declines as various agricultural subsidies were slashed. Later on, some or all of these losses were recouped through successful agrarian lobbying for farm subsidies and controls on food imports. The protectionist lobbying of West European farmers provided ideal role models for the rent-seeking and protectionist agrarian parties in the East.

As a result, extraordinarily high payroll taxes and import tariffs have been imposed on the working populations in the postcommunist countries. The payroll tax rates are among the highest in the world, and seriously threaten the dynamism of the emerging market economies in the region. There are hardly any countries in the world with incomes of less than $5,000 per capita in which government revenues exceed 40 percent of GDP. Government revenues in the Czech Republic, Hungary, Poland, Slovakia, and Slovenia all exceed that level.

These transfers might be justified as a onetime historical bargain, in which the burdens are shared by younger workers and future generations. So far, however, governments in the region have not designed the pension and farm benefits as onetime transfers, in a specific historical context. Rather, the entire fiscal structure has been distorted on an open-ended basis. The generous retirement benefits and protectionist measures have been implemented as permanent policy measures. Of course, these generous measures could be reversed later on, but probably only in an intense fiscal crisis. Almost no country in the world has yet been able to roll back long-established entitlements benefits.

Undo a Fiscal Legacy

In the next few years, the most important fiscal task in Central and Eastern Europe will be to reduce the size of social spending to more reasonable proportions of GDP. Political elites, Western governments, and the international financial institutions, including the IMF and the World Bank, will have to focus public attention in Eastern Europe on the looming fiscal crisis. The public should understand the crucial difference between a onetime intergenerational transfer to older workers at the start of market reforms, and a long-run pension policy. In any viable long-term arrangement, the level of benefits relative to wages should be reduced; retirement ages should be raised to international norms; and eligibility for special pension benefits (e.g. disability) should be tightened to cover only those truly in need.

In institutional terms, long-term reform should aim for a shift to a pension system based on individual savings accounts, as in Chile, as opposed to the current state run, pay-as-you-go pension systems. The individualized savings schemes let each household choose its own desired level of savings according to its particular intertemporal preferences and circumstances. The individualized system also eliminates the debilitating sense of universal entitlement that helped to bankrupt the old regimes and that still pervades the new ones. The privatization process can be linked to the pension reform, by earmarking privatization revenues or enterprise shares now held by the state to help finance the changeover to a private, individualized pension system.

Of course, the election results throughout the region demonstrate just how hard a task these needed reforms will be. Various governments have flirted with pension reforms, but none has progressed far and still survived the electoral test. Reformers, politicians, and international advisers should focus on improved public understanding and on innovative transitional strategies for pension fund reform in order to undo the continuing adverse fiscal legacy of the ancien régime.

OECD: Organization for Economic Cooperation and Development.
Note: All variables are averages for 1985-90.
a. Per capita GDP is measured in purchasing power parity terms, in 1991 dollars.
Source: United Nations, World Development Handbook, 1994.