Spending slash and tax rise aim to save Romania

Salary cuts and VAT hikes will surely be painful - but will they really be gainful? Crisis report by Claudia Ciobanu

Romania is struggling to adopt austerity measures to guarantee further bail-out cash from the International Monetary Fund (IMF) and keep in line with the EU trend of deep budget cuts.
The country is set to increase its VAT from 19 to 24 per cent and cut 25 per cent of salaries of state employees to maintain the 2010 budget deficit in the limits agreed with the IMF.
The Government wanted to keep the VAT unchanged and slash pension spending by 15 per cent, but the most powerful veto in the land - the Constitutional Court - ruled this was against the laws of Romania.
The Governing Democratic Liberal Party (PDL) had been adamant that a VAT hike should be avoided to protect the private sector and keep prices down.
In May, it had agreed with the IMF to cut state salaries by 25 per cent and pensions and most forms of social assistance by 15 per cent to contain the budget deficit for 2010 at 6.8 per cent of GDP.
Reductions in both salaries and pensions would have saved around 2.6 to 2.7 billion Euro or 2.3 per cent of GDP, but affected 5.5 million pensioners and 1.36 million workers.
Criticised by unions who opposed the severity of the cuts, Finance Minister Sebastian Vladescu argued that without these reductions in pensions and salaries, “Romania could pass from what is now a deep recession to something the country has not experienced yet - an economic crisis.”
However the Constitutional Court declared the pension cut illegal. The new measures also included laws to reduce high pensions granted to ex-state functionaries, such as diplomats, judges and pilots, which are a huge drag to the state budget.
These controversial “gold-plated pensions” include remuneration that can reach up to 100,000 Euro per year. But the Court opposed these reductions in special pensions for magistrates.
This decision postpones indefinitely the upcoming 850 million Euro from the IMF to Romania.

Bail-out halted

In 2009, Romania contracted a 20 billion Euro loan from the IMF, the EU and international financial institutions targeted at central bank (BNR) reserves to keep the currency stable, but also to cover budget expenses for that year. To receive the next tranche, the creditor had asked Romania to take measures to contain its budget deficit – which is predicted to rise to eight billion Euro for 2010.
The Government had said that there was no alternative to cuts in salaries and pensions. However, with the Constitutional Court decision and the IMF waiting for fast deficit reduction measures, Prime Minister Emil Boc announced that VAT would increase by five per cent.
Discussing the VAT hike, the Minister of Finance declared: “I do not like having to use the second best solution - in no way do I think this is the best measure for Romania today.”
A VAT increase of five per cent could generate up to 1.8 billion Euro annually in Romania, considering the country’s patchy tax collection rates, estimates economist Cristian Orgonas in his blog.
The VAT increase was included in the country’s fiscal code on 28 June. The Par-liament approved a modified version of the law concerning the cuts on 29 June, adopting the salary reductions.
But the main opposition parties are still working on ways to block both the tax rise and the salary cuts. On 15 June, the Liberal (PNL) and Social Democratic (PSD) opposition failed to pass a motion of censure against the executive by merely eight votes. The Socialists are planning another motion against the government, while the Liberals are preparing to contest the salary cuts in front of the Constitutional Court, on the grounds that they breach the right of workers to their collective contracts.
The IMF was set to meet on as we went to press to decide the fate of its payments to Romania.
Following the Court decision, the leu fell sharply against the Euro and the Dollar. In the absence of a functional deal with the IMF, the cost of Romania borrowing on the international financial markets could skyrocket. The current level of indebtedness of Romania is 30 per cent of GDP but, according to President Traian Basescu, this would rise to over 60 per cent by 2013 if future IMF payments are compromised.

Business versus hikes

The envisaged cuts in salaries could have a negative effect on Romania’s development. Frontline staff in hospitals and schools will see salary slashes and could be tempted to leave the sector, which could have a long-term effect on the country’s education and health. The reductions will also slash the public’s spending power and lead to a decrease in consumption.
However, many representatives of the business environment argue that even radical cuts across the board are preferable to a VAT rise of five per cent.
A large VAT increase places a serious burden on a private sector already pummelled by the crisis. It might push many companies into either bankruptcy or the black economy, which would see diminished revenues through the VAT system. As a direct tax, a large VAT increase reflects in price increases on most products and services.
Only a smaller VAT increase, of one to two per cent, could be absorbed by the business environment, argues Peter de Ruiter, head of tax and legal services at PricewaterhouseCoopers Romania.
“In other countries, a small increase in VAT has an inflationary effect for a short time and then nobody notices,” explains de Ruiter. Firms should be able to pass additional costs to consumers without a major impact.
Such a small VAT increase, however, would not be sufficient to reduce the deficit to the degree the IMF demands.
There are fears that the five per cent VAT hike announced by the government might cause a double-digit inflation. However, given that demand is expected to go down because of the salary cuts, analysts expect that companies will be forced to absorb some additional costs themselves rather than transfer them fully to customers. “I hope inflation stays below ten per cent, given the effects of the austerity measures on aggregate demand,” said ex-Finance Minister Daniel Daianu, quoted by Hotnews.

Non-virile stimulus package

Romania is estimated to have no growth or a one per cent contraction this year, according to rating agencies and the World Bank. With the economic crisis looming over the entire Europe, foreign investment has dried up and there is decreasing demand for Romanian exports.
In this climate of crisis, the bulk of the Romanian anti-crisis strategy is centered on austerity measures. As stipulated in the agreement with the IMF, the Government must eliminate 70,000 jobs from the public sector - while ministers have announced this figure may rise to 100,000. The Government also hopes to reduce spending in public administration by over 15 per cent and revise the social security system to eliminate welfare fraud.
But few measures to stimulate growth have been announced. The Government has pledged to boost the construction sector by building new state housing and promised to pay its arrears to companies. By 2011, its intention is to sell off minority stakes in its transport and energy assets, such as gas producer Romgaz and oil and gas group Petrom, to create one billion Euro for infrastructure development, which could help keep domestic employment buoyant. EU structural funds should also assist in stimulating the economy, but Romania’s absorption of these funds is running at eight per cent of the available cash.

Collection boost necessary

While the executive struggles to pass any anti-crisis measures, experts argue that improving tax collection fast is crucial, which could mean tougher sentencing of tax evaders and a more efficient structure of tax collection.
Historically, Romania has a weak rate of tax collection compared to its western colleagues. Experts quizzed by The Diplomat estimate that the rate of collection could swing between 50 and 80 per cent of the available monies, which are among the lowest in Europe.
PricewaterhouseCoopers’ Peter de Ruiter explains that if collection was undertaken at the western EU levels of over 90-95 per cent, Romania would probably have no budget deficit and there would be no need for an IMF loan.
The expert has praised the “good start” made by the government with the existence of an evasion law. “A framework kind of evasion law would be useful, allowing the authorities to have a general approach without being restricted by specific, dedicated measures,” he adds. “We want to encourage the Ministry of Finance to come up with a longer term plan.”
But by the time we went to press, one of two new laws to combat tax evasion had been passed and seriously weakened.
The Government had given up jail sentences for managers of companies who fail to pay taxes and an intention of the Government to introduce border VAT payments for EU foodstuffs - criticised by the EU for breaching the freedom of goods in the union - was also unlikely to materialise.
Critics of the state sector’s structure argue that Romania has allowed the public administration system to remain unreformed because the country was experiencing economic growth, so did not sense that radical change was necessary.
“All measures taken in Western countries are geared towards better expenses management,” says Florin Gherghel, tax adviser at law firm Noerr Romania. “The Romanian state needs to do the same, to spend money carefully and transparently, to improve tax collection and to reimburse VAT to firms so that the business environment survives the crisis.” The expert is sceptical that such ambitious reforms will be completed in the near future.

Looking outside

Capping and cutting social security costs could be a means for Romania to stimulate business activity, thinks Peter de Ruiter from PwC. “Overall, the insurance principle should prevail (in structuring social security) and people should not pay more than their risk is,” he says. In this way, Romania would benefit from a lowering of labour costs.
Other incentives for the business sector that the government might consider include, according to Gherghel, tax exemptions for re-invested profits and tax breaks for companies that might be negotiated with the EU, reverse charge VAT measures for companies and ensuring tax authorities return the VAT on time.
Another possibility would be to raise income tax above the current flat rate of 16 per cent. Since 2005, the aim of the flat tax was to bring clarity to the tax system, encourage foreign investment and bring in tax collection from the grey economy. Economists do not believe that the policy, on its own merits, was a failure. However the game has changed since 2005. Raising the income tax or switching to a progressive rate might generate more revenues, but it could deter the already scarce foreign investments, as neighbouring countries practice similarly low flat rates in a regional competition over investors.
Most central and eastern European countries have low flat rates at the moment because they want to stimulate foreign direct investments, but western European countries have progressive rates.
Minister Vladescu has argued that all options for changes to key levies such as the flat tax could be on the table for 2011.
“Eventually, central and eastern European countries will pass to progressive rates on the taxation of the income of physical persons,” argues Ioannis Paschalis, economic counselor at the Embassy of Greece in Romania. “What they should do is get together and make a gentleman’s agreement allowing all of them to change the flat tax rate at the same time, without losing investors.”
Alternatively, experts say that a lowering of taxes in times of crisis could have a stimulating effect. Companies would make smaller contributions to the state, but they would be less keen to evade paying taxes and their running costs would drop.

Taking on the banks

The idea of a bank tax is perceived with scepticism in Romania, where most analysts think it would place an additional burden on the finance sector, restraining them from granting credit and slowing economic recovery.
However Minister of the Environment Laszlo Borbely has declared that a tax on banks would be discussed with representatives of the central bank (BNR), as a potential measure to stimulate recovery.
The UK, France and Germany have committed to imposing levies on banks and financial transactions and the EU is already promoting the idea of a global financial transactions tax. In the EU, the funds generated could be used as a ‘guarantee fund’ in the eventuality of another bailout, needed by a member state or a major financial institution. A tax on financial transactions could also limit the volume of financial speculation, which many think lie at the root of the European sovereign debt crisis.

Austerity versus stimulus: the regional view

Greece - VAT increase focus

Greece, the country worst hit by the sovereign debt crisis, plans to cut at least 4.8 billion Euro of budget expenses this year through a series of measures centered around a VAT increase from 19 to 23 per cent.
Among the other steps taken by the Socialist government are combating tax evasion and corruption, freezing salaries and pensions for at least three years, raising the retirement age and curbing early retirement, cutting bonuses in the state sector and increasing taxes on fuel, alcohol and tobacco by ten per cent. Greece has this year received a bailout package from the IMF and the EU totaling 110 billion Euro. Its budget deficit is 13.6 per cent and public debt is higher than the GDP. This, together with concerns over corruption and inefficiency, have raised the cost of borrowing on the financial markets beyond Greece’s reach and still make it possible that the country might default on its debt. But officials in Athens and Brussels are keen to stress that the country is on the right path to recovery.
Statements from the EU and national governments showing trust in the economies are important to limit rough financial speculation.
“Greece was a case for speculators to make a pilot project targeting the Euro, to make it reach parity with the dollar and later buy a lot of Euros,” argues Ioannis Paschalis, Embassy of Greece. “Later, when the dollar becomes weaker, they will return to take the profits. What they did in 2008 with the banks during the US sub-prime crisis they are now trying to do with countries.”
Paschalis criticises the role of the international rating agencies Standard and Poor’s, Moody’s and Fitch during these years of crisis: “They are synchronised when it comes to downgradings, but not synchronised when it comes to upgradings,” he says. “They downgraded the Greek debt, one after the other, in a short time and then other countries in the Eurozone followed. This kind of synchronisation brings benefits to speculators. Somebody gets cash billions because the value of government bonds goes down.”

Hungary - a tax on banks

Hungary was one of the earliest central and eastern European countries to feel the brunt of the economic crisis and is burdened with one of the largest public debts in the region - the European Commission puts the level of public debt for 2010 at over 80 per cent of GDP. In 2008, Hungary received a 20 billion Euro bailout package from the IMF, the EU and the World Bank. Austerity measures implemented by the then-Socialist government included raising the VAT from 20 to 25 per cent, eliminating the “13th month” bonus for public-sector workers and pensioners, freezing salaries for state employees, raising the retirement age, cutting sick-leave pay and freezing child subsidies. The country was thus able to maintain a 3.9 per cent deficit in 2009.
In early June, the new conservative Fidesz government announced a levy on bank profits, tax cuts for big businesses and promised a flat 16 per cent income tax for 2011. Gergely Gimes, an analyst with Budapest-based consulting institute Political Capital, told The Diplomat that the plan of Prime Minister Viktor Orban’s Government to tax financial institutions to raise 600 million Euro stands a “good chance” of becoming a law, because of Fidesz’s Parliamentary majority. “The opposition and the population will support it and it is only meant to be implemented for three years,” he adds.

Bulgaria - tapping into the fiscal reserve

Bulgaria was running a budget surplus when the effects of the global economic crisis reached the region. This year, the centre-right government has given up the EU objective of maintaining a three per cent budget deficit, in spite of statements from EC officials saying Sofia could have achieved this goal. The ruling GERB plans to exceed that target and go to four per cent to avoid unpopular austerity measures. Last month the government announced it will tap into the country’s reserves, which are controlled by a currency board as the currency is pegged to the Euro. The country will make 0.9 billion Euro from 3.2 billion in the reserve available for use.
The nation will use the reserve funds along with any money obtained from reducing the state apparatus to invest in infrastructure, paying arrears to businesses and increase funds for social assistance. The most important taxes will remain unchanged and no change has been made in the level of state salaries and pensions, even though the possibility of freezing them has been discussed publicly. In June, Bulgaria announced it would not renew its contract with ratings agency Fitch.

Ukraine - looking east for IMF alternatives

In 2008, the Ukraine was affected by a banking crisis, which forced the government to recapitalise banks and take two banks under state administration. The Ukraine suffered a loss of 15 per cent in GDP last year, leading the country to seek an IMF loan on the basis of a stand-by agreement with the institution to the value of 13 billion Euro (dating from October 2008). Last year, the centre-right government took some measures to contain budget expenses through freezing pensions and increasing taxes such as the ones on tobacco and alcohol. But the IMF asked for more determined actions to make sure this year’s deficit will be kept at six per cent. Under the new leadership of pro-Moscow Viktor Yanukovich, while waiting for the IMF money to come through, in June this year, the Ukraine took out a two billion USD (1.6 billion Euro) loan from Russia.

Moldova - growth from liberalisation

The Republic of Moldova, which received an IMF loan to the value of 570 million USD (470 million Euro) in 2009, is starting to show signs of recovery, according to the IMF. This recovery is largely export-driven and a result of recent measures to liberalise trade, argues the Fund. Even though the Republic is predicted to have a growth of over two per cent of GDP in 2010, a better performance may be prevented by rising energy prices and the still shaky economic situation of its trading partners. The centre-right government of Moldova has also been promised 100 million Euro in aid from Romania - 25 million of which is to be delivered in 2010.