The communist regime in Bulgaria fell in 1989, but substantive economic reforms did not begin until early 1991. Then, from 1992 on, the pace of reform slowed and privatization of state enterprises was delayed; introduction of a value added tax was deferred a number of times and was only introduced in 1994. Only a handful of state enterprises had been privatized by the beginning of 1995.

The private sector has at the same time grown substantially, contributing 22 percent of GDP in 1994, according to official statistics. Recent World Bank estimates—which encompass illegal and quasi-legal activities, as well as legal activities outside of the government tax base—suggest, however, that the private sector contributes 50 percent of GDP. The Bank calculations also suggest that 90 percent or more of profits in the economy may accrue to the informal private sector. Although the private sector secures most of the accrued profits, its share in productive inputs is extremely low: some 5 percent of long-term assets, less than 10 percent of total credits, 22 to 26 percent of employment, and 10 to 12 percent of labor income. This suggests that private sector profits are somehow channeled from the state enterprise sector.

Intricate Links

The profits have not been used for investment; even according to the most optimistic estimates, private sector investment for 1993 did not exceed 12 percent of total investment. Investment in the state enterprise sector has been insufficient to maintain the capital stock, let alone facilitate modernization and restructuring.

The relationship between private and state firms appears to offer an explanation for the discrepancies between private sector profits and the private sector's low resource use. Under socialism, economic activity was vertically integrated to include all stages of production, processing, distribution, and marketing, including foreign trade. There was no market, and no market prices. Following the 1991 reforms, state enterprise managers were given autonomy in decisionmaking. As a general rule, private firms took over distribution, marketing, and foreign trade functions, while the state enterprise sector remained specialized in physical production. The private sector thus filled the void left by the departure of the planners.

Private and state firms, although distinct legal business entities, often function as if vertically integrated. Transfer prices rather than market prices govern- interfirm relationships. The transfer pricing opens the way for shifting profits from the state to private agents and facilitates tax evasion.

Relationships between state and private firms can be formally based on service contracts approved by the government and on open-tender leases of state enterprise facilities. Formal dealings appear, however, to be less prominent than informal activities. The following examples are illustrative.

• A private firm supplies a state firm with inputs. The state firm transforms the inputs and delivers the output to the private company. The state company has been isolated from the market.

• A state enterprise is authorized to lease land and equipment to a private firm through competitive tender. The successful bidder, however, is not the company that made the best offer, but the one with the closest tie to the managers. (In some cases, the owners of the winning private firm are themselves the state enterprise managers.)

• A private firm uses the production facilities of a state enterprise, on an "informal" basis. Payment is made to the state enterprise managers for use of the facilities and to compensate for the enterprise contracting out its unskilled workers. The private firm, nonetheless, uses its own skilled workers within the state enterprise plant. These relationships appear to have influenced both the pace of privatization of state enterprises and the pace of tax reform.

The Consequences

Taxation.In 1992 and 1993 the private sector contributed about 15 percent of all profit tax payments. For indirect taxes the share amounted to 10.0 percent in 1992 and 16.2 percent in 1993. After the introduction of a value added tax in the second quarter of 1994, the private sector share in total indirect tax payments increased to 43.2 percent, which is in line with estimates of the private sector's share in GDP. The value added tax thus substantially increased the private sector's tax payments.

The introduction of the value added tax to replace the turnover tax had been postponed several times since 1990. Under the system of informal arrangements between private and state enterprises, the turnover tax, which was levied only on sale for final consumption, could be readily avoided. State enterprises could rightly claim that sale of products or services to private firms was for further resale. The turnover tax was not well enforced in the private sector, allowing the tax to be evaded altogether. The value added tax, once finally implemented, substantially increased the private sector's tax payments, since the private sector was the repository of value added via the transfer prices.

Efficiency and social equity. The relationship between private and state firms affects efficiency and social equity. Efficiency is enhanced by complemen-tarities due to specialization of state and private firms—if otherwise idle resources of state enterprises are productively employed. There is no guarantee, however, that resources will be efficiently used, because the business relations between the state and private sectors are not competitively determined. With state enterprises profits syphoned to the private (informal) sector, the "losses" of state enterprises have been significant (15.3 percent of GDP in 1992, 17.6 percent in 1993, and 5.6 percent in 1994). Under such circumstances social equity considerations can affect the willingness of the public to accept market-oriented reforms—"markets" in these cases appear unjust.

Because of the absence of private title to ownership, private agents have reason to fear that the state-owned enterprise will be privatized away from them, and hence are deterred from investing. This endangers the long-term viability of the state enterprises. There are also clear indications that private sector agents dislike the prospect of a broadly based voucher scheme, which could threaten both their control over ventures and their continued profits. Direct sale of the firm to a "strategic" investor (themselves) would not do that.

To close the circle, the preprivatization valuation of the state enterprise depends on its profits. By "milking" the cow but not paying the market price for the milk, or by supplying the "feed" but overcharging for it, private individuals reduce the value of the state enterprise, if and when privatization by direct sale to a "strategic" investor proceeds.

These business relations are not open, and are, at best quasi-legal. Avoiding market transactions by state enterprises to increase private profit is a common practice in transition economies. In countries where spontaneous privatization occurred, private wealth was created by the transfer of state assets to private agents. In Hungary, for example, managers anticipated socialism's demise and were ready for spontaneous privatization; but in some countries things happened too fast, and state assets were not privatized spontaneously. In the Czech Republic state assets were transferred to the public in a broadly based, swiftly implemented privatization program based on voucher sales. In Bulgaria private wealth has been created through syphoning profits from state enterprises, rather than through privatization of the state enterprise assets themselves.