With the move to a market economy the number of small businesses has grown substantially in most transition countries. However, cumbersome legal provisions and administrative practices and the lack of a culture of voluntary compliance often provide strong incentives to operate outside the formal economy. The paper first discusses the growth of the SME sector in the region and its impact on tax policy and tax administration. It then describes approaches chosen by different countries in the region to reduce the tax burden and compliance costs for SMEs. It shows that the design of a clear and reasonably fair simplified tax system is a task which often has been underestimated by Ministries of Finance and tax administrations. As a consequence, simplified taxation systems risk to lack stability and transparency. With a growing and increasingly powerful small business lobby in transition countries policy makers face more and more pressure to further reduce the small business tax burden, risking to broaden the gap between the simplified and the standard tax system and to provide incentives for the use of evasion and avoidance techniques by larger businesses as well as employees. The paper looks at policy changes in Georgia, Ukraine, Russia, and Albania and analyzes their motives and impact. In the final section the paper shows that, despite the often very generous tax reductions offered by simplified regimes, these regimes have not significantly altered the tax behavior of SME operators. Small businesses generally continue to view the tax system as a key obstacle to business development and the overall tax burden as too high. This may partly be due to the fact that simplified regimes in many cases have been introduced in lieu of income tax only, so that the business operator continues to be confronted with a large number of tax obligations and high compliance costs. Working Paper Number 03-18.
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