Exchange Rate Volatility as a Strategic Constraint on Tax Revenue Performance: Evidence from European Transition Economies

Abstract

Background: Tax revenue performance is a central indicator of fiscal capacity and macroeconomic stability, particularly in small and open transition economies. While existing research highlights that macroeconomic volatility can weaken revenue mobilization, empirical evidence on the fiscal consequences of exchange rate volatility in European transition countries remains limited and fragmented. Given rising external exposure, evolving monetary regimes, and ongoing institutional reforms, understanding how exchange rate instability affects tax revenues is of growing policy relevance.

Purpose: The purpose of this study is to examine whether exchange rate volatility undermines tax revenue performance in selected European transition economies. To this end, the paper evaluates the magnitude and robustness of this relationship, while accounting for macroeconomic, fiscal, and structural determinants of tax revenues.

Study design/methodology/approach: The analysis employs a two-way fixed-effects panel framework using annual data for ten European economies over the period 2006-2024. The sample includes Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Montenegro, North Macedonia, Romania, Serbia, and Slovenia.

Exchange rate volatility is measured using an integrated annual indicator derived from daily conditional variances estimated through a volatility model. The empirical specification controls for economic development, growth dynamics, inflation, government expenditure, public debt, trade openness, and production structure. To ensure reliable inference, robust standard errors are applied to address heteroskedasticity, serial correlation, and cross-sectional dependence.

Findings/conclusions: The results indicate a statistically significant and negative relationship between exchange rate volatility and tax revenue performance. Specifically, a 1% increase in exchange rate volatility is associated with an approximate 0.034 percentage-point decline in the tax revenue-to-GDP ratio. This demonstrates that higher exchange rate instability is associated with lower tax revenues relative to economic output, suggesting that currency volatility acts as a source of fiscal fragility rather than a stabilizing mechanism. Ultimately, the findings underscore the importance of exchange rate stability and coordinated monetary–fiscal frameworks for ensuring predictable and sustainable revenue mobilization in transition economies.

Limitations/future research: The study is limited by its small country sample and the static nature of the empirical framework. Future research could extend the analysis to a broader set of countries, apply dynamic modeling techniques, and explore the asymmetric or nonlinear effects of exchange rate volatility on tax revenues.