Comment: Tax Cuts Will Boost Romanian Economy

Tuesday, 2 August, 2005

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Matei Paun

Romania has had a long wait to get a daring and creative political leadership that could help drag the country out of the post-communist morass it has languished in for 15 years.

So far, the first steps taken by the new government represent a welcome attempt to act on some of the areas most in need of reform, including tax, capital markets and corruption.

The new government’s first initiative – pushed through rapidly by an emergency decree – came just before the New Year as Romanians were preparing to uncork their champagne.

The cornerstone of the restructured tax system is a flat-rate of 16 per cent, replacing three income tax bands ranging between 18 and 40 per cent, and a corporate tax previously at 25 per cent.

Tax on share dividends has risen from five to ten per cent, while turnover tax on small businesses has doubled from 1.5 to three per cent.

The changes have two main aims: to simplify a currently Byzantine fiscal system, and to lower the overall tax level so that tax-dodgers have more of an incentive to pay up.

Since tax evasion is almost a national sport, with the underground economy estimated at close to 50 per cent of the whole, tackling it is a major issue for government.

The shake-up also sends a message to the world that Romania is serious about competing for foreign investment. It is taking place in the context of a general regional trend towards lower flat tax rates in Eastern Europe. Now Romania is joining the bandwagon, and at a very competitive level.

While some have voiced concern about a potential shortfall in revenue, the government maintains that lower taxes will actually increase its income since people will be less inclined to avoid paying.

For this to succeed, the new government will need to combine the carrot of tax cuts with a stick - giving teeth to hitherto ineffective laws and clamping down on persistent tax evasion.

In another move to pre-empt a possible revenue gap, the government is considering raising excise taxes on petrol, alcohol and cigarettes. That is a welcome move, as it will shift the burden of taxation from producers to consumers. By dampening consumption, it will motivate people to save and invest, and weaken inflationary pressures.

Now that the government has taken a major and visible step towards improving the business climate, it must follow up by reforming the restrictive labour code and lowering the level of social contributions that are currently payable on salaries. Now running at 48.5 per cent, the plan is to reduce employer contributions to 38.5 per cent by 2006.

In a further bid to generate revenue and stimulate Romania’s liquidity-starved capital markets, the government intends to list shares in the Greek-owned national telecom operator, Romtelecom, as well as in the national oil company Petrom, a majority stake of which was recently sold to Austria’s OMV, on the Bucharest stock exchange. BCR, Romania’s largest bank, and the CEC savings bank have also been mooted as possible candidates for a listing on the exchange.

It is refreshing to see such creativity and boldness in a country that has seen little of either since it abandoned communism over 15 years ago.

And it is reasonable to expect that a strategy this aggressive will mean another bumper year for Romanian capital markets. Last year, the main index at the Bucharest stock exchange grew by 93 per cent. This should also invigorate the derivatives markets that, though currently moribund, are still much-needed.

A few caveats need to be set out here. The new government should be concerned about the appreciation of the leu and the widening trade and current-account deficits.

Though inflation appears to be under control and is predicted to fall from 9.3 per cent in 2004 to seven per cent this year, Romania needs to implement a comprehensive set of policies to mitigate the effects of its soon-to-be-liberalised capital controls.

Global liquidity in search of high yields will increasingly seek out Romania, bringing with it not only rewards, but also the potential for loss of equilibrium and speculative bubbles.

The government must also make clear its resolve to repair Romania’s reputation for corruption. It has already said it intends to review state contracts worth 3.6 billion euro, representing important infrastructure and defence-related commitments, which its predecessor negotiated under less than transparent conditions.

The new government has also moved in determined fashion against RAFO, an oil refinery seen as one of the most prominent examples of corruption and tax evasion. Nineteen executives and shareholders have been placed under investigation and their funds sequestered.

Furthermore, the government is expected to call in foreign investigators to assist Romania’s overstretched and often compromised prosecutors.

The international community should welcome these measures.

Romania has made an excellent start to improving its image, but these are only first steps and the country will need all the help it can get if it is to succeed.

Years of mismanagement have left Romania lagging behind its more reformist neighbours. It must be hoped that in the run-up to European Union accession, Romania has found the courage to apply many of the policies and solutions that have made successes of other post-communist countries.

Matei Paun is an economic analyst, and is managing partner with the financial consultancy firm BAC Romania