“One of the great mistakes is to judge policies and programs by their intentions rather than their results” – Milton Friedman
The journey Georgia took to become an independent, free, economically and politically stable country was anything but peaceful. After the breakup of the Soviet Union in 1991 and the ensuing civil war, the economy contracted by 65 percent over three years until 1993—an unprecedented economic collapse even among former Soviet Union states. During 1992-94, inflation averaged nearly 7,000 percent. As Georgia’s relationship with the Russian Federation deteriorated, Moscow tightened the screws on the economy, severing trading connections and imposing sanctions that led to a collapse in Georgia’s GDP. Further exacerbating the situation was the declaration of Georgia’s pro-Western aspirations, after which it lost access to cheap energy from Russia. Given that these two economies were so intertwined, Georgia struggled with the Russian Federation’s 1998 economic crisis and rising corruption levels. According to 2002 World Bank data, Georgia had the largest shadow economy in the world. The problem was so substantial that not even the positive economic trend of 2003 was enough to thwart the Rose Revolution, whose main slogan was ‘fight against corruption’.
Before we discuss the reforms that saved the country, we need to examine the reasons for Georgia becoming such a corrupt country in the first place. Although the transition from socialism may have improved general transparency, both democratic politicians and tax officials were still biased when creating the tax system design. In 1999, to achieve the projected budget revenues on paper, the government resorted to deceptive accounting techniques such as ‘‘forwarding’’ budget funds from one budget line to another and making fictitious tax offsets. This was because Georgia had an almost-empty treasury due to the previous government interventions and mistakes. We are often blind to the fact that newly formed democracies are still very vulnerable to corruption. Politicians often think that they have to be concerned more with what the taxation system looks like to the voter than with how it performs. Therefore, they will have the same tendency as the socialist regimes that preceded them to support taxation that is as hidden from the public as possible. Corrupt tax officers will take advantage of any discretionary situations.
The Rose Revolution marked a turning point in Georgia’s political and economic history. After the new presidential and parliamentary elections, Georgia underwent significant governance reforms. The economy was in a severe condition when the new party came into office. To send a clear message that corruption would no longer be tolerated, the government emphasized tax collection and the prosecution of prominent corrupt business people and government officials. After 2003, which was first fuelled by anti-corruption and a deeply ingrained mistrust of state authority dating back to the Soviet period, they started this process by establishing a liberal deregulation program. These changes led to a significant reduction in state control and drastic privatization of commercial relationships. As a result, formal rules lost their ability to reflect and maintain power structures. The distribution of economic advantages shifted from the formal to the informal sector due to low regulatory density and the prevailing dogma of non-intervention. The dynamic of Georgia’s economic environment demonstrated that the introduction of libertarian reforms was vital to preserve not just the majority of businesses but the whole economy and the nation’s well-being. High marginal tax rates significantly reduce the returns from productive endeavors, making it less attractive for people to work and undertake profitable business projects. High taxes in less developed nations frequently force corporate activity into the illegal or black markets, where the justice system is less stable and property rights are less protected. High rates frequently cause a shortage of workers and other productive resources in industrialized economies. The new government reduced some tax rates and adopted a new Tax Code in late 2004. Remarkably, the number of taxes went down: more than twenty taxes under the old tax code and other laws were reduced to only seven through abolishment or combination. The new tax code was simplified. VAT and payroll taxes were reduced, while flat income tax replaced the old progressive income tax. Reforms were also implemented in public registries, business regulations, customs, traffic police, and entrance examinations for higher education.
The results were astounding. Tax collections increased from 12 percent of GDP in 2003 to 25 percent in 2010 on the back of tax reforms. Georgia’s standing in global rankings improved dramatically. Concerning the post-Soviet business environment, the country became a leader thanks to these extensive pro-market and governance reforms. Even The Economist observed that reducing the size of the state, which would reduce chances for graft, would naturally have the effect of reducing corruption in Georgia. Additionally, tax cuts ensured that the government’s newly hired, young, and primarily Western-educated workers received high enough wages to resist the temptation to commit corruption.
Scholars suggest that Georgian politics during that time can be seen as the realization of von Mises and von Hayek’s liberal economic theory. The Georgian economy was strengthened by the comprehensive deregulation program and the reduction of the state’s obligations to provide a neutral and minimal regulatory framework, leaving behind the fate of an area historically notorious for corruption and high criminal activity. Georgia was recognized by the World Bank as the top worldwide reformer for five years (2005- 2010) as a consequence of the ongoing advancement of economic conditions. Georgia had a record-breaking GDP growth rate of 12.5% in 2007, one of the top 3 growth rates that year due to tax reduction and simplification.
A country doesn’t necessarily have to be a democracy to be economically free. In the case of Hong Kong, it is anything but democratic, still managing to keep an open market. Neither does democracy guarantee economic freedom. Before 1990, India was democratic but maintained one of the least free economies in the world. However, it would be naïve of us to assume these two factors do not work in confluence most of the time. Georgia’s case demonstrates once again that economic freedom, while itself an essential component of total freedom, is also necessary for political freedom.