Selected Issues and Statistical Appendix
Author:
International Monetary Fund
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Publication Date:
16 Jan 2001
eISBN:
9781451832716
Language:
English
Keywords:
ISCR; CR; bank; exchange rate; inflation; price; Romania; tax authorities; government employment; income tax; personal income; personnel expenditure; Social security contributions; Employment; Value-added tax; Eastern Europe
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This Selected Issues paper analyzes the developments and determinants of inflation in Romania, and reviews the salient trends in public finance. The study describes the monetary policy issues and the improvements required to clean up the financial sector. The paper chronicles the balance-of-payments crisis in 1999, the external viability trends, reviews the economic and financial implications, and assesses Romania's compliance with EU economic criteria. The paper also provides a statistical appendix for the country.

Abstract

This Selected Issues paper analyzes the developments and determinants of inflation in Romania, and reviews the salient trends in public finance. The study describes the monetary policy issues and the improvements required to clean up the financial sector. The paper chronicles the balance-of-payments crisis in 1999, the external viability trends, reviews the economic and financial implications, and assesses Romania's compliance with EU economic criteria. The paper also provides a statistical appendix for the country.

II. Public Finance 1990-20001

A. Introduction and Overview of Fiscal Policy

1. Despite important progress toward more efficient and sustainable public finances over the last decade, Romania’s fiscal position remains precarious. Following the collapse of the Ceaucescu regime in 1989, public finances were in a highly imbalanced state, as was the entire economy. With haphazard and often inconsistent reform efforts in the following six years—coupled with large increases in fiscal cum quasi-fiscal deficits—major macroeconomic imbalances had emerged in late 1996, and urgent reform became inevitable. A new reform government faced the immediate task of averting a crisis. While fiscal consolidation proved very difficult, by the end of the 1990s the health of government finances was much improved. This was accomplished by arresting the buildup of debt, curtailing quasi-fiscal subsidies, and improving the tax policy environment, and, perhaps most importantly by cutting the overall size and deficit of government operations. Nevertheless, the fiscal position has remained precarious as indicated by persistent problems in budget preparation and implementation. This calls for further reform to prioritize and streamline expenditures and restore the viability of the pension system.

2. The excessively expansionary fiscal cum quasi-fiscal stance pursued up until 1996 necessitated a sharp correction in the subsequent years. Between 1992 and 1996, the consolidated government deficit had reached an average of 3.1 percent of GDP, compared to recorded surpluses throughout the 1980s. Moreover, in an effort to support economic sectors facing hardships, significant quasi-fiscal deficits were also incurred (see Box II.1). While the ensuing profligate fiscal cum quasi-fiscal stance helped to secure the early recovery of output—compared to many other transition economies—it also set the stage for severe inflationary and balance of payments pressures, which came up to the fore at the end of 1996. The subsequent task of fiscal consolidation was only made more difficult by the eventual fiscalization of earlier incurred quasi-fiscal debt—mostly in the form of recapitalizing insolvent banks and calling of loan guarantees. This resulted in new expenditure pressures, particularly on debt servicing, which were further exacerbated by the liberalization of interest rates.

3. A substantial fiscal adjustment has been undertaken since 1997 through cuts in primary expenditures and increases in revenue. The initial focus was on expenditure cuts concentrated on wages, pensions and capital. These, however, had to be partially rolled back under political pressure, and substantial tax increases were implemented in 1998 and early 1999. At the end of 1999, revenue collections had rebounded to the same share in GDP as in 1993, while primary expenditure in relation to GDP was significantly lower than in 1990-96. As a result, the primary balance improved by almost 5 percentage points of GDP between 1996 and 1999 (see Statistical Appendix, Table 24). However, an almost equivalent increase in interest expenditures limited the improvement in the overall deficit to only 1 percentage point during the same period.

Quasi-Fiscal Operations and Deficits

Quasi-fiscal operations quickly increased in the early 1990s and by 1996 had reached very large levels. The rapid expansion of such activities—beyond the level witnessed in other transition economies in Central and Eastern Europe—was a reaction to efforts to bring the fiscal deficit under control, most notably the 1993 reduction in transfer and subsidy spending by 6 percent of GDP. The quasi-fiscal operations took the form of (a) subsidies through the extension of directed low-interest credit by the NBR to agriculture and energy–intensive sectors; (b) sharp increases in lending by state-owned commercial banks to the same sectors; (c) NBR sales of foreign exchange at an appreciated exchange rate to the energy sector; (d) a pickup in the extension of government loan guarantees; and (e) a general increase in payments arrears by state owned companies. The following summary table provides a quantification of some of these factors (annual flows in percent of GDP):

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While these activities ceased following the exchange and interest rate liberalization of 1997, much of their cost was subsequently brought on budget, either through recapitalizing state-owned banks in 1997 and 1999 (in a combined amount of some 8 percent of GDP), or through lowered NBR profit transfers to the budget.

The extent to which these quasi-fiscal operations gave rise to deficits, however, is less clear. While much of the bad bank loans eventually found their way into the budget in 1997 and 1999—thus supporting the notion that these were not backed by any offsetting quasi-fiscal revenue at the time—an assessment is somewhat more difficult as concerns the support extended by the central bank (in terms of directed lending, interest subsidies, and exchange rate subsidy). Clearly, the NBR was able to rely on its own seignorage income (only part of its profits were supposed to be passed on to the budget), and part of the exchange rate subsidy to energy intensive importers was financed by an implicit tax on exporters who had to sell their proceeds at the too appreciated rate. However, several factors point to the fact that indeed significant quasi-fiscal deficits were recorded: seignorage revenue averaged around 2.5 percent of GDP over the period, below the combined total of NBR support to industry and agriculture; exporters found ways to sell their proceeds on the parallel market, thus evading the implicit export tax; and the NBR witnessed a considerable deterioration in its net foreign asset position over the period, which it financed by foreign borrowing at market interest rates.

4. The focus of reform now has to shift toward a prioritization of government functions in line with available resources. On the one hand, substantial quasi-fiscal operations have been eliminated and the share of government expenditure in GDP is now in line with economies like the U.S., albeit considerably lower than in the EU countries or more advanced transition economies. This reflects difficulties encountered in tax administration and collections as well as a policy effort by government to limit its use of productive resources. On the other hand, the Romanian system of public finance attempts to emulate all the features of a European-type welfare state, which—in order to be sustainably financed— would require a significantly higher revenue collection than is currently the case. In addition, the public pension system has become increasingly unsustainable and the needed augmentation of outlays in key social sectors as well as projected new expenditure obligations—notably associated with Romania’s efforts to accede to the European Union, and to join NATO—will need to be financed. In order to achieve fiscal sustainability—an important ingredient to the so far elusive macroeconomic stability—a choice between a concerted effort at increasing revenue collections or cutting the reaches of government spending and welfare entitlements thus needs to be made.

5. The task is far from easy and considerable downside risk is present. Attempts to increase revenue have in the past been largely met by increased tax evasion and/or arrears accumulation while the only effective way to control (real) expenditures has been higher-than-targeted inflation. In the period ahead it is, therefore, important to maintain the efficiency gains made in tax policy; to greatly improve tax administration; to streamline spending; and to reform the pension system. Failure to progress along these fronts could again rapidly undermine the health of public finances.

6. In the remainder of the chapter, the most important developments in the areas of revenue and expenditure policy during the last ten years will be reviewed. The analysis will be geared toward identifying the remaining immediate and future challenges. Accordingly, considerable attention is devoted to the incentive effects of tax policy (especially on labor supply and demand) and on needed reforms in the areas of wage and employment policy, as well as of the unsustainable pension system. The chapter also seeks to identify trends in public debt and interest payments, and concludes with a brief review of the main medium-term challenges.

B. Revenue Policies

7. The downward trend in revenue collections has now been reversed, and important efficiency gains have been recorded in tax policy. The share of revenue collections in GDP in 1999 has rebounded to a level last recorded in 1993—an experience unique among transition economies, which, in general, have witnessed a continuous erosion and eventual bottoming out of revenues. Tax policy has become more efficient: the importance of income- and wage taxation has been lowered, thereby reducing distortions and incentives for rent-seeking activities as well as non-wage labor costs (however, continuous increases in social security contributions—necessitated by increasing imbalances in the pension system—largely offset this beneficial effect). At the same time, more reliance is being placed on broader-based indirect taxes which generally are easier to administer and subject to fewer distortions (see Table II.1).

Table II.1:

Composition of Revenue, 1990-2000 1/

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Sources: Data provided by the Romanian authorities and staff estimates

Data for 2000 refer to developments through June 30,2000, and are affected by seasonality.

Prior to 1993, turnover tax.

8. The following paragraphs take a more detailed look at tax policy and developments in tax administration and also compare developments to the experience of other transition economies. Appendix II-l summarizes the Romanian tax system as of September 2000, while Appendix II-2 provides a description of changes in income and value-added taxation since 1996.

Company income taxation

9. Short-run attempts to balance the twin objectives of raising revenue and providing incentives for investment undermined the integrity of company income taxation throughout the 1990s. The profit tax was introduced in 1990 to replace the communist-era confiscatory profits transfer tax.2 However, already early on, further progress in making the tax more efficient was hampered by ad hoc and frequently reversed measures on tax holidays and other "tax incentives" (see Box II.2), which were typically based on short-term assessments of the relative importance of revenue collections vis-à-vis investment promotion. Far from benefiting investment and employment, these frequent changes and the attendant instability of the regime—described as “tax mayhem” by private-sector legal experts—eroded the credibility of tax policy, and made holding out a more valuable option for potential investors.

Tax Holidays and Investment Incentives

In an effort to mitigate the effects of high statutory profit tax rates, especially in the absence of proper inflation accounting on new investment, the authorities found it desirable to introduce tax holidays and other selective incentives into the tax code at numerous stages during the 1990s. The following provides a brief timeline:

  • In 1991, generous company tax holidays and investment tax allowances were introduced. Over the next two years, these measures—along with the ongoing economic contraction—contributed to a steady erosion in company income tax collections.

  • In an effort to strengthen revenue collections from companies, the 1991 tax holiday provisions were partially rescinded in 1994. However, law 71 of the same year awarded new long-term tax holidays selectively to foreign investors.

  • New tax holidays and tax cuts for companies (including on customs duties and VAT) were introduced in 1997 through Emergency Ordinance (EO) 92, and subsequently generalized to a larger class of beneficiaries through law 241 of 1998.

  • In order to avoid the sharp loss of revenue implied by the coming on stream of the latter tax cuts, the 1999 budget law suspended for one year all tax holidays and incentives, including those already awarded.

  • In an effort to secure a major privatization deal, government passed EO 67 of 1999, granting even more generous selective tax holidays and cuts.

  • In mid-1999, a moratorium was put on the implementation of the EO 67 in order to stem the potential loss of revenue and efficiency of the tax code, limiting its application to one company.

  • In July 1999 Law 139 was passed which extended the benefits of EO 67 to small- and medium-sized enterprises.

  • Beginning in 2000, with the previous suspensions and moratoria set to expire, companies were set to benefit from complete or partial tax holidays which could have been granted through a number of laws or through the discretion of government agencies. Tax holidays would have also been available for actual or planned investments in excess of differing amounts (starting at US$500,000), for companies of differing sizes (specified in terms of employment or turnover), for reinvested earnings (in some cases without any expiration date), and for investment in areas with high unemployment or other disadvantages.

  • Instead, in early 2000, a comprehensive reform of company income taxation was undertaken, reducing the statutory rate, introducing an investment tax allowance, and abrogating and repealing E067 and Law 139 of 1999, as well as all other provisions suspended in the 1999 budget law.

10. By the beginning of the year 2000, the corporate tax regime was set to undergo further drastic changes. The need to increase revenue collections had led to the imposition of various one-year moratoria on, and suspensions of, tax holidays in 1999. On the one hand, with the lapse of these moratoria in 2000, large-scale revenue losses, estimated at 2 percent of GDP, and stark distortions of business taxation would have resulted. On the other hand, the statutory taxation of companies in Romania was considerably more onerous than elsewhere in the region. The statutory tax rate of 38 percent was the second highest in Eastern Europe and—given the absence of proper inflation adjustment—implied the highest effective tax rate on investments (ETR) in the entire region, more than twice as high as in the country with the second highest taxation (see Table II.2).3 The available tax holidays would have put company taxation to the lowest comparable level, at less than half the next lowest ETR (see Bergsman, Chen, and Mintz (1999). Since not all companies would have benefited from these holidays, stark tax distortions would have arisen, which would have been compounded by the effect of inflation on taxable income. With high levels of inflation, no proper adjustment of tax liabilities, but unlimited deductibility of interest expenditures for taxable profits, the tax system was extremely tilted in favor of companies able to raise debt finance.4

Table II.2:

Comparison of Company Income Taxation

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Sources: Bergsman, Chen and Mintz (1999); and staff estimates.

Estimates for the manufacturing sector.

Indicates the situation where suspensions and moratoria expired.

Assumes that investments benefit from all available incentives, including tax holidays.

11. The 2000 reform has greatly improved the investment climate, and brought Romania’s company taxation more in line with regional standards. Most importantly, all previous tax-holiday and investment-incentive legislation was abrogated and the statutory tax rate lowered from 38 to 25 percent, while an investment tax allowance of 10 percent was introduced, which established an indirect inflation adjustment into the tax code.5 After the reform, the effective taxation of investments is close to the levels in Poland and Slovakia.6 Moreover, the expected deceleration in inflation should also mitigate the detrimental incentives posed by unlimited deductibility of interest expenditures.

12. However, some challenges remain. The lower taxation of company income arising from exports—subject to an estimated ETR of only 1 percent—has introduced new distortions and administrative difficulties, and, in due course, will lead to calls for similar beneficial taxation from other sectors.7 Subject to overall fiscal resource availability, a preferable approach would have been a further lowering of the standard rate, eschewing the introduction of sector-specific rates. Another challenge will be to strengthen centralized authority in the area of tax policy so as to end the practice of special agencies (for example, the Romanian Development Agency or the Agency for Regional Development) initiating tax holidays. Such noncentralized power to grant sector-specific tax incentives has done much to undermine the credibility and stability of the tax system, and every effort should be made to avoid a relapse into past practices.

Wage-based taxes

13. Considerable progress has been recorded in modernizing personal income taxation and reducing adverse incentives for employment throughout the decade. However, the perilous state of the pension system, as well as attempts to introduce a broad wage-taxed financed social welfare system, have prevented a lowering of non-wage labor costs, imparted through wage-based taxes.

14. Overall wage-based taxation has been driven by diverging developments in personal income taxation and social security contributions(see Figure II.1). In the early transition period, the share of both components in GDP increased sharply, reflecting mainly the regressive bias imparted by bracket creep in a high-inflation environment and the increasing share of labor in GDP. However, successive tax cuts, adjustments in brackets, as well as weaknesses in tax administration had by 1997 resulted in lower collections of wage-based taxes than in the pre-transition period. For wage taxes, this trend continued unabated, as new tax cuts resulted in a further reduction in personal income taxes. However, collections of contributions picked up again in 1998 when the by then precarious state of pension fund finances resulted in the first drastic increase in social security contributions.

Figure II.1:
Figure II.1:

Trends in Wage-Based Taxes, 1990-99

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 016; 10.5089/9781451832716.002.A002

Personal income tax

15. The burden of personal income taxation has been drastically reduced. In 1992, Romania had a personal income tax schedule with 13 brackets and marginal rates from 6 to 45 percent. There was no general allowance level—i.e., income became taxable with the first leu earned—except for special cases (e.g., participants in the 1989 revolution).8 The top marginal rate was further increased to 60 percent in 1993, but the number and classes of exempted tax payers continued to grow. Recognizing the pernicious effects of such high marginal tax rates, as well as the strong pressure for exemption of additional groups, the authorities rolled back the increase of the top rate in 1997 and 98, reduced the number of brackets, and decreased the spread between the top and bottom rates. However, the addition of new exemptions, as well as the attendant administrative difficulties, led to sharply reduced effective tax rates—as measured by the difference between average gross and net wages—so that in 1998 the effective tax rate was 16 percent, well below the statutory minimum of 21 percent (see Figure II.2).

Figure II.2:
Figure II.2:

Trends in Statutory and Effective Wage Tax, 1992–2000H1

(In percent)

Citation: IMF Staff Country Reports 2001, 016; 10.5089/9781451832716.002.A002

16. The income tax reform of 2000 aimed at broadening the base while further reducing marginal rates, and lowering the tax burden on low-wage earners. In January 2000, the previous schedular system was replaced by a global income tax law, which covers all sources of personal income. However, difficulties in administration will ensure that the tax will continue to be predominantly based on withheld wage taxes.9 Against the background of the adverse incentive effects of high top marginal rates, the reform also included a further reduction in the top rate to 40 percent with a simultaneous increase of the bottom rate to 18 percent (thereby lowering the spread from 35 percentage points to 22 percentage points). So as to mitigate the impact on low-income earners, the general tax free allowance was more than doubled to about 40 percent of average wages.

Social security contributions

17. Following significant increases in statutory social security contribution rates, there are signs that collections in relation to GDP have now reached an upper limit.10 After initial increases in 1990 and 1991, statutory social security contribution rates were kept unchanged at 35 percent of gross wages through 1997.11 The statutory rate was increased to 43 percent in 1998 and 60 percent in 1999, reflecting both the establishment of the National Health Insurance House modeled on the German system, as well as the dramatic deterioration in the finances of the pension fund (see below). Apart from the large implied increases in nonwage labor costs—ceteris paribus equivalent to a 25 percent increase in real wages over two years—and the attendant adverse effects on employment and inflation, these increases also resulted in sharply lower compliance (see Table II.3). Moreover, the level of contributions is now by far the highest compared to the region and western Europe.12

Table II.3:

Selected Indicators on Social Security Contributions, 1997-2000 1/

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Sources: Data provided by the Romanian authorities.

Data for 2000 refer to the first six months.

Estimated on the basis of actual contributions collected by potential contributors.

18. Declining compliance was facilitated on the one hand by attempts at needed labor market liberalization, and, on the other hand, by increasing tolerance to nonpayment of obligations by large public enterprises.

  • In an effort to stimulate part-time employment, so called “civil contracts of employment” were introduced in 1995. These were intended to be constrained to small-time and contractual employment, which was at the time thought to not require pension coverage. Accordingly, such contracts were only made liable to wage tax and health insurance contributions. Subsequently, employment under such contracts witnessed sharp increases—in contrast to the ongoing and unchecked decline in employment governed by standard labor contracts subject also to pension and unemployment contributions. Reflecting the urgent need for labor market liberalization, the growth was not confined to part time jobs, as regular employment relations became increasingly governed by such civil contracts.

  • At the same time, contribution arrears by large state owned companies—many of them in sectors subject to higher-than-standard pension contributions—were allowed to balloon.13 The resulting increases in arrears are even understated given the low penalty rate over much of the last four years, that permitted an erosion of the real value of these arrears. While the pension fund was given legal means to enforce better payment performance—notably through seizing bank balances and shipments or deliveries, as well as the option to convert such debt into shares for sale to investors—concerns about the adverse employment effects of such actions have in the past prevented a more forceful enforcement of payments due.

19. There is an urgent need to reverse the unsustainable level and composition of social security contributions. In an effort to increase the number of contributors, in May 2000, the authorities took steps to increase the tax base by subjecting civil contracts to all social security contributions.14 However, it is doubtful, as early revenue collections indicate, that the resulting 41 percentage points rise in non-wage labor cost for such contracts will generate additional revenue as opposed to further tax evasion (for example, by shifting work into uncontracted arrangements, which would in addition result in a loss of wage tax revenue so far collected under civil contracts). At the same time, the buildup of arrears to the pension fund has continued unabated. While in the recent past, the reductions in the personal income tax have mitigated the adverse effects of higher social contributions on the cost of employment, such mitigation is unlikely to be available in the future given the now rather low level of personal income taxation. Instead, it is now imperative to enforce strict payment discipline, and to dramatically turn around the financial position of the pension system (see below), to be able to improve incentives for employment.

Indirect taxes

20. Over the last decade, substantial progress was made in introducing a modern system of indirect taxes. However, collection efficiency has considerably fallen short of potential, reflecting both genuine administrative difficulties, but also inconsistent attempts at steering the tax burden into politically desired directions. With a reform in early 2000 undoing much of such unproductive regulation, it is now important to concentrate on urgent administrative improvements.

Value-added tax

21. VAT collections have only recently begun to reverse the downward trend since the inception of the tax. The VAT was introduced in mid-1993 to replace the turnover tax. With a statutory rate of 18 percent, international experience would have suggested that revenue collections of 9 percent of GDP were well within reach. However, actual collections declined from 5.3 percent of GDP in 1993 to 4.6 percent in 1997, with the effectiveness of the tax—i.e. the share of actual to theoretical collections—on a downward trend (see Table II.4).

Table II.4:

VAT indicators, 1993–2000 1/

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Sources: Data provided by the Romanian authorities; and staff estimates.

Data for 2000 pertain to the first 6 months.

22. This poor performance reflects the fact that, from its inception, tax administration became heavily burdened by a large number of exemptions and multiple rates, and by difficulties of tax administrators in adjusting to the fundamental difference in the nature of the VAT from the previous turnover tax:

  • Multiple rates were quickly introduced. While the VAT was introduced with a uniform rate of 18 percent, a reduced rate of 9 percent was added shortly thereafter in 1994. The lower rate was designed to cover basic and educational goods, but, in rapid additions, also began to apply to public transport and newspapers. Moreover, in sharp contrast to international practice which, in line with the “destination principle” levies a zero rate only on exported goods,15 Romania also subjected domestic consumption goods like electricity and gas to a zero VAT rate.

  • Large scale exemptions were provided. Initially reflecting an attempt to further cushion the adverse impact of a consumption tax on poorer households, entire classes of goods were exempted. However, further exemptions were provided for services provided by self-employed, many of which did not command a high proportion in poor households’ consumption baskets (such as lawyers’ services, cultural performances, and spa holidays).

  • The tax authorities took time to adjust to the administrative requirements of a VAT. The self-enforcing element of the VAT was greatly weakened by the delay in adjusting tax administration to the difference between a final consumption tax and a turnover tax. In particular, a successful VAT depends on the prompt payment of credits to taxpayers for VAT paid on inputs, particularly for exporters. However, a conservative approach toward processing requests for reimbursements led to long delays, during which, in addition to the carrying costs for the tax payer, high inflation substantially reduced the real value of the eventual credit, and in practice reintroduced some of the distortions of the earlier cascading turnover tax. Moreover, the delayed processing of reimbursements and refunds undermined the self-enforcing character of a VAT, i.e., for producers to register and pay VAT, so as to be able to claim such credits; and incentives for evasion remained large.

  • The VAT was used as a tool for providing business incentives. Recognizing the adverse impact of delayed reimbursements for company profitability, the authorities found themselves compelled early on to award selective VAT exemptions to specific companies (see Box II.2). However, the award of such exemptions for one company only triggered demands for similar treatment from additional companies, notably competitors and suppliers, thereby undermining the base of a successful VAT, which for its proper functioning, needs to rely on an unbroken chain of tax payments and invoices through all stages of production up to final consumption.

23. A comprehensive VAT reform to redress these problems was launched in 2000. An initial attempt to improve the revenue yield in 1999 relied on an increase in statutory rates, but had limited success, as further requests for exemptions or coverage at the lower rate proved impossible to ignore. In contrast, the reform launched in January 2000 included the following elements designed to move the VAT closer to an ideal type, embodying a single positive rate, zero-rating for exports, and as wide a tax base as possible:

  • The statutory rate was lowered and unified. While the standard rate was reduced from 22 percent to 19 percent, it is still higher than the 18 percent rate in place through 1996. In addition, the reduced rate was abolished, thus effecting a VAT increase of 7 percentage points on goods previously taxed at the lower rate of 11 percent. Moreover, Romania is now one of the few countries in Europe with a uniform rate—albeit a comparatively low one.16 Finally, the zero rate is now limited to exports. Actual collections through mid-2000 suggest that this reform has been almost revenue neutral.

  • Exemptions were reduced from 19 groups to three.

  • The processing of credits and refunds was speeded up. In a first step, export-oriented large-scale companies were beneficiaries, but the new procedures are expected to quickly benefit all other tax payers.

  • Selective company-specific VAT exemptions were generally revoked. Against the background of speedier processing of VAT reimbursements, the demands for company-specific VAT exemptions were expected to drop, and most such arrangements have now been cancelled. However, to the extent that they do remain (primarily in politically important enterprises), they still constitute an anomaly that severely impedes the proper functioning of a VAT and would best be phased out at the earliest possible opportunity.

24. The stage is now set for a major improvement in VAT performance. International experience would suggest that with the reform in place, a significant increase in VAT collections, up to at least a level of 9 percent of GDP over the next several years, should be possible. This would imply a 30 percent increase in real VAT collections, and should serve as a yardstick in designing tax administration improvements.

Other indirect taxes

25. The administration of excise taxes has been subject to frequent and contradictory shifts, and continues to be plagued by poor collection performance as the tax authorities continue to play catch-up with tax avoiders. Excises were introduced in 1993, as part of the tax reform program abolishing the turnover tax. They are levied on petroleum, alcohol and tobacco products, as well as passenger cars and selected luxury goods. From the beginning, their administration proved difficult, and the authorities undertook numerous reforms to tackle the underlying problems. Initially levied at specific rates, their yield was quickly undermined by rapid inflation. However, the change to ad valorem rates did not significantly improve matters as the tax authorities found it difficult to detect cases of declared undervaluation of the excisable product. To address the latter problem, excises were returned to a specific valuation, but in euro terms, thereby obviating the need for frequent inflation adjustments. However, tax evasion quickly shifted to redenominating excisable products into non-excisable ones, resulting in a 15 percent fall in real excise collections in the first 8 months of 2000. Recently modified legislation now seeks to put less ambiguous definitions of excisable products in place.

26. Revenue from trade taxes increased quickly in the early stages of transition, but has recently been declining. With the opening of trade and the tariffication of quantitative restrictions, customs receipts increased from close to zero to 1.5 percent of GDP in 1993. This level has on average been maintained through 1999, notwithstanding further trade liberalization and the proliferation of exemptions. However, in view of the build up of significant current account pressures, the authorities felt compelled to introduce a general import surcharge of 6 percent in 1998. The surcharge has since been reduced to 4 percent in 1999, and 2 percent in 2000, and is scheduled to be eliminated in 2001. Reflecting continued difficulties in customs administration, trade tax collections are currently projected to fall some 25 percent in real terms to 1.1 percent of GDP in 2000, and can be expected to fall lower still, given the need to lower tariff rates in preparation for EU accession.

C. Expenditure Policy Issues

27. After large increases in fiscal cum quasi fiscal expenditures in the first half of the decade, a corrective tightening has been achieved, setting the foundation for improved fiscal sustainability. By 1996, unsustainably large spending had resulted in a debt level which had become burdensome to finance. The stabilization effort begun in 1997 effected a drastic reduction in primary spending, accommodating the higher interest costs and making an important contribution to an improved fiscal position in the future. However, the pension system has clearly became unsustainable. The following paragraphs will discuss some of the relevant issue in more detail.

Personnel expenditures

28. Throughout the decade, attempts at expenditure consolidation were complicated by difficulties in trimming personnel outlays. While the share of government wage expenditures in GDP up to 1996 was about in line with other transition countries, the share of wage expenditures in total government expenditures, at some 20 percent was relatively high.17 A drastic cut in wage expenditure effected in 1997—resulting from sizeable reductions in employment and wages—proved not to be sustainable, and wage expenditure has subsequently inched up again. The following points discuss the reasons behind these developments in some more detail (see also Figure II.3).

Figure II.3.
Figure II.3.

Romania: Indicators of Government Personnel Expenditure, 1990-99

Citation: IMF Staff Country Reports 2001, 016; 10.5089/9781451832716.002.A002

Source: Data provided by the Romanian authorities.

  • Despite the move from plan to market, government employment has increased over the last decade (Figure II.3, Panel 1). In the first six years of the 1990s, the budget had increasingly assumed the role of employer of last resort, and government employment had grown some 10 percent to more than 903,000 by end-1996. Notwithstanding repeated attempts, it has proved politically difficult to reverse these increases, and employment has been reduced only by some 4 percent to 870,000 at end 1999.18 In fact, reflecting the ongoing restructuring in the rest of the economy, and the resulting decline of formal employment, the share of government employment in total employment has continued to increase, from 9.4 percent in 1990 to 17.7 percent in 1999.

  • Early attempts at reducing remuneration proved unsustainable (Figure II.3, Panel 2). While real wages and dollar wages declined by one third between 1990 and 1993, difficulties in maintaining morale and attracting qualified applicants, and the electoral cycle all put pressures on salaries in the following years. Against this background, average monthly government wages have risen to a historic high of US$110 by mid-2000, driven by initial wage increases in the education and defense and security sectors, which proved themselves politically hard to withhold from other government employees.

  • Government wages have caught up again with wages in the rest of the economy (Figure II.3, Panel 3). Arguably reflecting higher job security, wages in the government sector, which started out at close to the average wage level in the entire economy, initially fell behind wages in the rest of the economy, so that by 1996 the average civil service wage had fallen to some 80 percent of the economy-wide average. Since then, partly owing to lower wage growth in public enterprises, the differential has been largely eliminated, and with the hefty wage increases accorded recently, is projected to reach a historic low in 2000.

  • Efforts were also undertaken to secure critical operating outlays (see Figure II.3, Panel 4). While initial efforts at controlling budget spending early in the 1990s were centered on cutting operating expenditures—also resulting in the accumulation of some arrears—the ensuing decline in the quality of public services necessitated increases in material allocations. Moreover, the establishment of a self-financing medical insurance scheme in 1998 helped to secure funding for medical services, which had suffered in prior years.

29. Making up for lost time, and reducing the size of government will be a key challenge in improving fiscal sustainability. The twin objectives of limiting the drain of government on the private economy, as well as improving the quality of government services will require a significant cut in overstating. On the assumption that a self-supporting growth process has taken hold in the economy, and that productivity is set to rise, there will be pressure on wages in the private sector, especially for critical skills. Moreover, further efficiency improvements through use of technology will likely result in higher material expenditure per employee. Government will only be able to compete for the needed skills as well as improve its operations if employment is cut. The government has announced plans in this direction which were, however, delayed in the run up to the elections.

Pensions

30. Romania entered the 1990’s with an already unsustainable pension system. While nominally a pay-as-you-go (PAYG) defined-benefit (DB) system, the financial health of the pension system was compromised by the extension of pension benefits to non-contributing employees—notably farmers and employees in agricultural enterprises—while contributions were kept at a level too low to cover the implied replacement rate. In addition, the benefits were based on only a fraction of a worker’s work history.19 On the other hand, with a relatively young population, demographic trends did not imply a worsening of the pension system’s finances.

31. Subsequent pension policy compounded the initial problems. Chief among the adverse policies pursued was the large expansion of the number of pensioners through legislative fiat, by introducing generous early retirement regulation, which has massively undermined the previously benign demographic trends (see Figure II.4).20 Furthermore, the DB link between a worker’s wage- and employment history and pension benefits was further weakened, most notably in 1996 when, in response to the political fallout of declining real pensions, the government passed a decision linking all pensions to the economy-wide average wage.

Figure II.4.
Figure II.4.

Romania: Pension System Indicators, 1990-2000

Citation: IMF Staff Country Reports 2001, 016; 10.5089/9781451832716.002.A002

Source: Data provided by the Romanian authorities, and staff and World Bank projections.1/ Before state budget subsidies.

32. In the absence of comprehensive reform, past “fixes” have compounded the underlying imbalance.

  • In the first place, social security contributions were increased in steps (see above). The large increases also raised non-wage labor costs of employment, thus contributing to higher unemployment as well as enhancing incentives for tax evasion. These adverse dynamics have materialized in a fall in the number of contributors to the social security system—at a time when the working age population actually increased by some 0.3-0.5 percent per year. Moreover, with lacking enforcement of financial discipline, large-scale and loss-making state-owned enterprises started to default on the employer contributions outright, which has led to a decline in the effective contribution rate collected. Finally, in conjunction with the very high contribution rates, the generous early retirement provisions have implied a very high implicit tax on additional work, further undermining the sustainability of the system (see Sin 2000).21

  • With efforts to increase pension fund revenue thus being met by only partial success, the curtailment of benefits assumed key importance. Efforts in this direction have progressed along two lines: first, the distribution of pensions was compressed by capping increases in high pensions while ensuring a higher rate of increase in low pensions—further eroding the DB mechanism.22 Secondly, pensions have been increased by less than the rate of inflation. However, both “solutions” had adverse implications. On the one hand, in the last three years, a cycle has emerged, in which a round of pension compression was followed by a round of “decompression”, while, on the other hand, caps on real pension benefits were being secured throughout by incomplete inflation adjustment. However, as much as inflation has permitted a control of real pension benefits, it has by the same token introduced ever larger demands for pension increases, heightening concerns about the sustainability of the pension system.

  • There have also been attempts at structural reform, so as to rid the system of non-core, non-insurance activities. In this vein, the farmers’ pension fund was abolished in August 2000, and folded into the public pension system. While the financial base of that fund had been narrow and underperforming, the measure nevertheless further worsened the financial situation of the existing system as no new revenue source was specified. Moreover, the authorities tried to widen the net of contributors in mid-2000 by subjecting workers under “civil contracts” (mostly part-time contracts) to full social security contributions (see above). However, the outcome has been mixed, reflecting both the high incentive for tax evasion given the implied effective doubling of the marginal wage tax rate, as well as the very poor administrative capacity for handling the new contributors.

33. The pension system is now unsustainable in a number of dimensions.23 The system is headed toward a dependency ratio (the number of pensioners per contributor) of 1 and higher, while statutory contribution rates have become unproductively large (they are on the wrong side of the Laffer curve), and pensions have reached an historic low. Meanwhile, the deficit of the pension system continues to increase.

  • An ever growing number of pensioners is met by continuing declines in the number of contributors. Under the present system—with statutory early retirement, selective early retirement for large segments of the workforce, and a ballooning number of disability pensions—workers retire on average at age 54 (men) and 50 (women), with just under 30 and 25 years of service, respectively. They are legally entitled to a lifetime pension of some 50 percent of their best 5 years of earnings— typically, given Romania’s inflation levels, the last 5 active years—while the life expectancy at pension age is 15 years for men and 22 for women (Sin (2000). These factors have resulted in almost a doubling in the number of pensioners between 1989 and 2000. At the same time, the number of contributors has fallen by almost 40 percent.

  • Contribution rates have reached excessive levels. They are not only extremely high by international standards, but imply further incentives for early retirement and tax evasion, as evidenced by the decline in compliance estimated above.

  • The replacement rate has continued to fall and put pensioners at a high risk of poverty. Both net and gross replacement rates are now less than 75 percent of levels recorded in 1993, with much of the decline having occurred in the last four years. An average monthly pension now amounts to some US$40. Given these developments, pensioners, who in the early to mid-1990s tended to be relatively better off than other population segments, have recently been identified as one of the major groups threatened by poverty.

  • Deficits of the pension system have continued to mount. After recording surpluses through 1994, the pension system had to subsequently rely on transfers from the central government budget to balance its books. By 1998, the deficit had amounted to 1.5 percent of GDP, and recent World Bank estimates project a deficit of some 2 percent of GDP for 2000.

  • In addition, the current system also fails the test for fairness, from both an inter-and intra-generational perspective. Regarding the first, it burdens future generations with ever higher contribution rates and/or lower replacement rates. Regarding the second, the lack of a proper DB mechanism implies net transfers to workers with less-than-complete work history.

34. Demographic trends have now also turned sharply adverse. According to World Bank projections, Romania’s population is projected to fall from 22.6 million to 19 million by 2050 (see Table II.5). During this period, the population will age rapidly, and the old-age dependency ratio will double. With these trends, a World Bank study has estimated that an unchanged pension system would require further increases in contribution rates (from 37.5 percent today to 60 percent in 2050) or lower replacement rates, from more than 30 percent at present to less than 20 percent in 2050 or a combination between these two (see Sin 2000).

Table II.5.

Demographic Trends, 1999-2050

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Source: Sin (2000)

35. Reform has been initiated. As a stop-gap measure, the authorities have identified urgent steps, which are slated to become effective next year. The self-employed are to be made subject to social security contributions; a “points system” linking wage history and benefits modeled after the German system, and designed to limit the replacement rate to 45 percent, is to be introduced;24 all pensions are to be indexed to the CPI; and the retirement age is to be increased by two years initially, and subsequently by another three years over a 13-year period.25

36. But more will need to be done. Even with these reforms, the financial decline of the public pension system is only projected to be arrested, but not reversed, with a deficit of 2 percent of GDP in 2001, falling only to 0.7 percent by 2005, and—after dramatically increasing in the interim—again reaching 1 percent of GDP in 2050. Moreover, the effect of these reforms will still need to be seen once they are implemented, and may in general not provide much of a short-term relief: given the very high contribution rates, the general extension of the obligation to contribute is likely to result in increased tax evasion;26 the maximum replacement rate guaranteed under the new law is still significantly larger than the current effective replacement rate of some 35 percent (a 14 percent increase) and—should this prove unaffordable—could no longer be adjusted in real terms by inflation, given the explicit full indexation mechanism; and the envisaged initial increase in the statutory minimum retirement age has reportedly triggered a substantial increase in early retirement in 2000, thereby already eroding the potential savings, and in any event will need to be protected by tightening eligibility requirements for disability pensions. The fact that the current legal minimum retirement age of 60 and 55 years for men and women, respectively, has been consistent with actual average retirement ages of 54 and 50 years highlights the need to tighten administrative procedures.

37. A more comprehensive reform will need to tackle the underlying problems in the public system, and tough choices will need to be made. As long as contribution rates persist at current levels, tax evasion will persist, or—if enforcement were considerably toughened—significant additional unemployment would arise from the implied increase in the effective cost of employment. A reduction in statutory contribution rates is, therefore essential. More ambitious increases in the retirement age may also need to be considered.27 Also, bringing the female retirement age in line with the male retirement age might be a useful measure. In any event, the outright elimination of, or drastic cuts in privileged pension categories will be essential, while tightened eligibility requirements for disability pensions and maternity leave need to be introduced, preferably accompanied by shifting their financing to the general government from the pension system. Moreover, it needs to be recognized that social protection schemes—such as the past “compressions”—have no place in DB entitlements, but should, instead, be met by budgetary social policy.

38. There is no “silver bullet” which can obviate the need for difficult reform. In particular, while being an essential addition to a sustainable pension system in the longer term, the introduction of a private fully funded pension system in the current circumstances may be premature.28 It will cut contribution revenue—by siphoning off previous contributions from the PAYG system to the funded system—while leaving the PAYG pension liabilities unchanged. In the short term this will increase the deficit, resulting in a transitory gap of some 1.5 percent of GDP over the next years, according to recent World Bank estimates.29 Such transitory gaps are a normal feature of introducing a funded system, and countries have typically relied on one or a mixture of the following mechanisms to cover the gap: cutting benefits, raising contributions, earmarking privatization revenue, or issuing debt. The difficulty is that none of these options is very attractive—or even feasible—in the current Romanian circumstances: the pension benefits and contributions have already reached unsustainably low and high levels, respectively; privatization revenue is projected to dry up, while issuing new debt and the attendant interest costs in fact will amount to a straightforward transfer of budgetary funds to the holders of such debt, which may not at this point be the best (or fairest) use of scarce public pension fund resources. Moreover, given the poor record of financial market development and supervision (seeChapter IV, some considerable caution is in order before private fund managers are licensed.

Other transfers and subsidies

39. Sharp increases in transfer and subsidy expenditures marked the beginning of the transition process. By 1992, subsidies and transfers amounted to some 23 percent of GDP, more than twice their level in the late 1980s. While much of the increase reflected poor classification of expenditure and the highly distorted public expenditure environment under the Ceaucescu regime, it is not out of line with developments encountered in other transition economies at the launch of the transition process. However, in Romania, the rise contributed to fiscal sustainability problems as it proved politically difficult to scale back these payments—and to avoid demands for the extension of new ones—while the overall budgetary revenue envelope tightened.

40. Reflecting increasing difficulties in financing these expenditures within a given budgetary envelope, a large share was moved off-budget in 1993. In particular, subsidies to energy-intensive industry and to agriculture were now starting to be extended in the form of directed credit (see Box II.1). In support of these operations, the National Bank started to incur large external debt—from a level of zero in 1992 to 4.8 percent of GDP by 1996—and major state owned banks accumulated significant non-performing loans. On the other hand, the removal of price difference subsidies resulted in the accumulation of large payments arrears.

41. After 1997, subsidy and transfer expenditures were reduced, the targeting was improved, but difficulties remained(see Figure II.5). In conjunction with full price liberalization, price difference subsidies were drastically reduced. On the other hand, it was possible to increase allocations for social transfers, in particular for child allowances—albeit to a level still short of levels prior to 1992—and temporary transfer payments resulting from severance payments in the mining sector were brought on budget. Nevertheless, overall social conditions are estimated to have deteriorated—not an unexpected outcome, given the overall economic situation.30 Also, while considerable progress was made in cutting subsidies and transfers to economic activities—in particular by ceasing quasi-fiscal support through the banking system—some sectors, such as public transportation and housing showed themselves resilient to cuts, in part, however, the result of explicit budgeting.31

Figure II.5:
Figure II.5:

Expenditure on Transfers and Subsidies, 1990-99

(Excluding pensions, in percent of GDP)

Citation: IMF Staff Country Reports 2001, 016; 10.5089/9781451832716.002.A002

Other primary expenditure

42. Material and operating expenditure have recently recovered from earlier cuts. In 1999, such spending amounted to 7.6 percent of GDP, up considerably from the level of 6.2 percent in 1996. While this is at the lower end compared to other central European countries, given data comparability difficulties, it would appear to be an adequate level for the time being, and to become more adequate once overstaffing is reduced.32

43. In a next step, fiscal reform will have to aim at improving management of material and operating expenditure. Part of the recent recovery in material and operating spending reflected efforts of line ministries to secure expenditure through earmarking revenues into self financing “special funds”. Indeed, the number of such funds has increased from 3 in 1992, to 25 in 2000. While these earmarking schemes have greatly limited the necessary room for budgetary maneuver to flexibly address shifting expenditure priorities, they have managed to increase the allocation to the health and roads sectors. The task is now to ensure that the allocations to such priority sectors result in efficient spending, well focused on priorities. Unfortunately, in the recent months considerable evidence has emerged that the special health fund is overwhelmed by administrative difficulties, resulting in wasteful spending in prestige projects, while key basic health funding has started to deteriorate again.

44. Capital expenditure and net lending declined throughout the 1990s. Much of the early reduction reflected the desirable elimination of unproductive showcase projects pursued under the Ceaucescu regime. In addition, the eventual acceleration of the privatization program after 1997 opened the possibility of private sector investment in infrastructure. However, there is evidence that recent cuts have begun to threaten the viability of the public infrastructure.

Interest expenditure

45. Notwithstanding Romania’s modest public indebtedness, interest expenditure assumed an increasing share of budgetary spending. Having started out the decade with essentially no debt, Romania quickly accumulated a sizeable debt burden in order to finance large fiscal and quasi-fiscal deficits (see above). In 1999, interest payments amounted to 5.3 percent of GDP, representing 14 percent of all government spending, the highest level among Central Eastern European countries, with the exception of Albania, largely reflecting the failure to bring inflation under control. Apart from the rapid buildup of debt in the early transition period and continuous high levels of inflation, the acceleration in public interest expenditure is explained by the extension of significant loan guarantees, which were increasingly called up; haphazard and ultimately only partially successful stabilization attempts; and the poor state of the domestic banking system. The following paragraphs discuss these points in more detail.

46. The early years of transition witnessed a rapid buildup of public debt. The nature of much of the debt financed expenditure is unclear, as budgetary accounts for the early years fail to show significant deficits.33 Moreover, selected industrial enterprises and the agricultural sector benefited from government loan guarantees which by 1996 had reached 6.8 percent of GDP. As the fiscal accounts became more transparent, the underlying deterioration in the primary balance became also more evident.

Table II.6.

Public Debt and Interest Expenditure, 1990-2000 1/

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Sources: Data provided by the Romanian authorities and Fund staff estimates.

Data for 2000 refer to June 30,2000.

Excluding debt of the National Bank of Romania.

Includes principal repayments as well as interest on called guarantees.

47. Contingent liabilities increasingly turned into actual ones. Two main mechanisms were at work here:

  • The state owned banking system, which until 1996 had served as a major conduit for quasi-fiscal subsidies to the heavy industry and agriculture, had accumulated a large nonperforming loan portfolio, and become arguably insolvent. Distress borrowing by ailing banks would have severely undermined the stabilization objective, and the government sought to recapitalize state-owned banks and to assume their accumulated bad debt. In this way, in 1997, government took over some three percent of GDP in additional debt for the purpose of partially recapitalizing Bancorex and Banca Agricola (see Chapter IV). However, continued poor management practices at these banks, as well as difficulties in financing past losses necessitated a renewed bail out in 1999, adding a further five percent of GDP in debt.

  • Loan guarantees which had been generously extended through 1996 became called up more frequently. Many of these guarantees were extended so as to finance current operating and subsidy expenditures for state enterprises and agriculture. With little or no productive investment backing up these liabilities, default occurred with increasing frequency, further burdening the budget.

48. Eventual stabilization attempts and price liberalization introduced positive real interest rates. Over much of the period through 1996, the government was able to raise domestic finance at negative real interest rates. However, with repressed inflation rapidly building up, the comprehensive price liberalization in 1997 necessitated sharply higher interest rates so as to keep inflation from accelerating further. Reflecting tighter monetary conditions, real interest rates turned positive. While a significant reduction in the primary deficit as well as some pickup in privatization proceeds and considerable foreign financing accompanied the 1997 stabilization program, the situation was aggravated by a lack of progress in fiscal consolidation in 1998. This contributed to a pernicious macro policy mix with too lose a fiscal policy and too tight a monetary stance. Correcting this policy mix necessitated a renewed stabilization effort—this time supported by a larger fiscal adjustment in 1999 and 2000—with real interest rates having recently been drastically lower.

49. The overall debt dynamics for the period ahead are not unfavorable. Provided prudent macroeconomic policies are pursued, it should be possible to reduce the share of the interest bill in GDP over the next years. Given the comparatively low level of public debt, interest expenditure will be highly sensitive to the choice of the primary surplus target. In an illustrative scenario, and assuming positive single-digit real interest rates, the maintenance of an average primary surplus (including grants) of some 2.3 percent of GDP would bring down government interest expenditure to some 2 percent of GDP by 2004.

D. Concluding Observations and Issues for the Medium Term

50. While important progress has been made in fiscal reform—especially over the last two years—critical issues remain for the immediate period ahead. In the first instance, there is a question of philosophy: the authorities need to decide which model of a government Romania is to emulate: a full fledged welfare state, or a smaller government more attuned to recently observed revenue performance. If it is to aim to the same structure as Western European welfare states, it will be important to raise revenue to comparable levels. If such a route is chosen, this will require tax administration to make massive inroads so as to break the past experience of revenue erosion. However, even if the choice is to aim for a less broad government, important actions need to be taken so as to preserve the recent advances in tax policy and improve tax administration and the composition of public expenditure.

51. By and large, tax policy has made great strides, and the advances need to be preserved. In particular, it will require vigilance to preserve the integrity of company taxation against attempts to reintroduce selective incentives. Not doing so would risk repeating the pattern of the 1990 that has done so much harm in tarnishing Romania’s reputation as a safe destination for investment. Building on the legal structure already implemented, an appropriately ambitious program of globalizing personal income taxation should be introduced. It will also be essential to improve tax administration, in particular to start bringing the VAT to its potential.

52. As concerns expenditure, a more sustainable way of keeping real expenditure allocations in check needs to be found. In the past, higher-than-targeted—and budgeted for— inflation has permitted the containment of real expenditure. However, this system has greatly burdened rational budget policy and is not sustainable as inflation expectations will ultimately run out of control; at any rate, it is inconsistent with the targeted disinflation over the medium term. Keeping expenditure in check will thus require real reform, particularly as concerns the reduction in overstaffing and a reform of the pension system. Moreover, recent problems regarding local authority finance and earmarked revenue will also be needed to be addressed.

53. Additional expenditure commitments are already on the horizon. First and foremost, the EU and NATO accession will put new demands on the budget (see Box II.3). In addition, efforts will have to be made to ameliorate social conditions and deep-seated pockets of poverty.

The Fiscal Implications of Accession to the European Union and NATO

Romania has entered in accession agreements with the North Atlantic Treaty Organization (NATO) and the European Union (EU) (on the latter, see Chapter VI). Both these plans will have important fiscal implications.

EU accession will require significant additional expenditure, particularly on agriculture, transport infrastructure and the environment. The EBRD estimates the annual accession costs for Romania to amount to 3.5 percent of GDP. While large grants from the EU have been earmarked to benefit these additional expenditures—SAPARD instruments for agriculture and ISPA instruments for infrastructure and environment, and PHARE instruments for institution building—averaging ∈650 million over the next 5 years, it is important to note that on a net basis, Romania will be confronted with an additional financing gap from EU accession, some 1 percent of GDP according to staff estimates. Many of the grants will require a domestic cofinancing component. Moreover, these grant-financed expenditures will in a short time give rise to recurrent operating and maintenance expenditure which have to be met from Romania’s own budgetary resources. It is, therefore, important that great selectivity and budgetary prudence be exercised in allocating the available grant finance on high-priority and sustainable projects.

Romania’s armed forces will have to undergo extensive restructuring in order to meet NATO requirements. At present, the Romanian armed forces structure is still characterized by a top-heavy mix with a large number of officers and conscripts, and a pronounced shortage of professional soldiers and non-commissioned officers (NCOs). In addition, the forces are not geared toward mobility and rapid deployment, while electronic communication, command, control, and intelligence (C3I) infrastructure falls far short of NATO standards. As a step in redressing these shortcomings, the armed forces, which amounted to some 204,000, were cut by some 26,000 staff since 1997, while conscription was cut by 11,000 in 2000 through greater selectivity. The target is to reduce force strength to 153,000 while reducing the numbers of officers and conscripts and boosting the ranks of NCOs and professional troops, which is, however, expected to be financed from the savings generated by the overall cuts. The cuts should also help to bolster the defense spending per soldier—which presently ranks among the lowest in Europe. On the other hand, additional capital outlays for upgrading readiness, mobility and C3I infrastructure can be expected to arise in pursuit of the targeted NATO membership in 2005.

Appendix I. Romania: Tax Summary 1/

(as of September 30, 2000)

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The table does not include local taxes set individually by local authorities.

Appendix II. ROMANIA:SUMMARY OF RECENT DEVOLEPMENTS ON VALUE ADDED AND INCOME AND WAGE TAXATION, 1996-2000

A. Value Added Tax

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B. Income and Wage Taxes

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Note: For residents of countries, with which Romania has signed agreements for the avoidance of double taxation, in the period 1996-2000, income earned in the form of interest, dividends, royalties and commissions is taxed at the source, under the conditions and at the rates specified in these conventions, beginning from the date of application of the respective agreements (the date on which each agreement goes into effect, as well as the tax rate levels, is shown in the annex).

SUMMARY of the agreements signed by Romania with other countries for avoidance of double taxation (As of July 11, 2000)

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*) The provisions of the agreement with the S.F.R. of Yugoslavia are applied in the case of Macedonia and Slovenia and for Bosnia-Herzegovina. Dividends ** When participation in the company’s capital represents at least 25% of the capital of the dividend-paying company. Exception: Bangladesh, with 10%, and likewise in the case of the Netherlands (new agreement) for the second rate; Pakistan, with 20%; Hungary, with 40%; Greece, 45% - distributing company residing [in] Greece; 20% - company distributing to residents of Romania.

References

  • Bergsman, Joel, Chen, Duanjie, and Jack Mintz (1999): Romania: Business Taxation and Incentives, Foreign Investment Advisory Services

  • Christou, Costas (2000): Balancing Fiscal Priorities: Slovakia’s Challenges for the Future: in: Slovak Republic, Selected Issues, SM/00/152

    • Search Google Scholar
    • Export Citation

  • De Menil, Georges, Hamayon, Stephane, and Mihai Seitan (1999): Romania’s Pension System: The Weight of the Past, mimeo

  • De Menil, Georges and Eitan Sheshinsky (2000): Romania’s Pension System: From Crisis to Reform, mimeo

  • Mintz, Jack (1990): Corporate Tax Holidays and Investment, World Bank Economic Review (International); 4:81-102 January 1990

  • OECD (1998): Economic Surveys: Romania

  • Pop, Lucian and Cornelia Tesliuc (2000): Poverty, Inequality, and Social Protection, in: Christoph Riihl and Daniel Daianu (eds.): Economic Transition in Romania, Washington, DC

    • Search Google Scholar
    • Export Citation

  • Sin, Yvonne (2000): Pension Reform in Romania, World Bank, mimeo

1

This chapter was prepared by Gerwin Bell.

2

Early reforms centered on a reduction in the number and the statutory level of tax rates. The number of rates, which had amounted to 68 (ranging from 0 to 77 percent in 1991 in an effort to introduce progressivity into company income taxation), was subsequently reduced to two in 1992 (30 and 45 percent), and further to a uniform 38 percent in 1996.

3

ETR is an analytical construct which aims to relate an investment project’s actual tax liability to its before-tax income in economic terms (i.e., including the effects of depreciation, operating expenses, inflation, etc.). The ETR can be either lower or higher than the statutory rate. It would be lower, if, for example, tax holidays reduce tax liabilities. It could be higher, if company profits were affected by inflation, but the value of the investment and depreciation allowances were not benefiting from revaluation.

4

In environments of high inflation and liberalized interest rates, actual interest payments include a large component of monetary correction, de facto amortization payments. Full deductibility of interest expenditure from taxable profits may, thus, result in extremely low— potentially negative—taxation of investments and thereby provide an incentive for excessive accumulation of corporate debt (see Mintz, 1990).

5

A new distortion was, however, introduced with a preferential 5 percent rate for profits arising from export activities.

6

It is worthy to note that the lower ETRs in the Czech Republic and Slovakia reflect their respective tax holiday provisions. Without tax holidays, investments in these two countries would face a significantly higher ETR than in Romania.

7

The tax is assessed by applying the share of export proceeds in total company turnover to taxable company profits. This assessment poses obvious incentives for overreporting export earnings.

8

Tax credits were, however, available, according to the number of children in a household.

9

Incremental withholding taxes on other income are, however, being introduced, for example, on pension income exceeding two million lei as of July 2000.

10

Social security contributions currently are collected by the pension and unemployment funds, health insurance, the risk, accident, and handicapped special funds, as well as a special fund used to top up wage payments in the education sector.

11

The contribution rates quoted in the text are based on the standard pension contribution rate (currently 35 percent). Special higher contribution rates of 40 or 45 percent apply in industries eligible for special early retirement benefits (e.g., mining and railways).

12

The statutory rate of 60 percent in Romania compares to 50 and 47.5 percent in the Slovak and Czech Republics, to 41 percent in Hungary, 43 percent in Poland, an EU average of 36.5 percent, and 25 percent in the OECD (see Christou (2000).

13

The biggest debtors to the pension fund are concentrated in steel production, refineries, and the railways, all subject to an overall 70 percent social contribution rate.

14

The number of contributors, at 5.3 million, is only 55 percent of the active population.

15

The zero rate would also apply to international transportation and diplomatic purchases.

16

Other transition countries typically have standard rates in excess of 20 percent, but also (sometimes multiple) lower rates. Among countries with a uniform rate, Romania’s 19 percent is lower than the 25 percent in Denmark, but higher than the 17.5 percent in the United Kingdom (see Christou (2000)).

17

This observation pertains to reported personnel expenditure. To the extent that countries include some personnel spending (e.g., for sub-national government levels) in transfer spending, this statement would need to be qualified.

18

These numbers exclude employment in the defense and security sectors, which amounted to some additional 130,000.

19

The benefit formula calculated a worker’s pension at 75 percent of the average wage earned in the in the five best consecutive years in the previous 10-year period.

20

In 1991, a comprehensive early retirement scheme was introduced which increased the number of pensioners by almost 40 percent (see De Menil and Sheshinsky (2000). Subsequent modifications relaxed early retirement provisions further for workers in selected employment categories, while at the same time greatly expanding the definition of these eligible categories. At the beginning of the decade, some 300,000 workers qualified for these categories, as compared to 2.3 million at present.

21

In conjunction with the absence of a penalty for early retirement—and the de facto option to work in the informal sector after retirement—the high contribution rates imply a very high tax on one additional year of work. The implicit tax amounts to the wage tax, plus the loss of one year equivalent of the lifetime present value of the pension. This becomes even more true to the extent that workers have been able to use ambiguous definitions so as to claim a disability pension when they have not yet achieved the necessary number of working years for a full pension. The number of disability pensions has tripled between 1990 and 2000, and now stands at 600,000.

22

There were some 50 indexation adjustments of pensions during the 1990s which, however, did not reverse the erosion of real pensions (De Menil, Hamayon and Seitan, 1999). Indexation increases were agreed between the Ministry of Labor and trade unions as well as employers’ and pensioner’s organizations. While initial increases were substantial and drastically increased the real value of pensions compared to preceding months, rampant inflation and delays in the following indexation resulted in steadily declining real pensions.

23

The same—however in even more drastic form—holds true for the farmers’ pension system. With a very small number of contributors (around 80,000), the fanner’s system supports 1.7 million pensions (up from a level of less than 1 million in 1989). Notwithstanding past and ultimately unsuccessful attempts to broaden its financial base by earmarking a food products tax, the system delivers only extremely small pensions.

24

The points system is designed to take into account a worker’s entire wage and employment history by assigning scores to every year of contributions. The score (points) will be a function of the worker’s monthly gross wage during any given year in comparison to the economy-wide monthly gross average wage in that same year. At retirement, a worker will have a number of points given by the sum of all the yearly scores. The system is to be calibrated by valuing the points such that a hypothetical newly retired individual who has worked each year of its work history at the economy-wide average wage will achieve a replacement rate of 45 percent.

25

The initial increase in the statutory retirement age to 62 for men and 57 for women only restores the legal statutory retirement age, which was previously subject to a generalized 2-year early retirement.

26

International evidence suggests that coverage of the self-employed is unlikely to raise significant revenue, as the administration of self-employed contributions is usually too complicated. Thus, many countries do not even try to mandate the self employed into contributions.

27

Given the projected demographic trends, this may also be required by economic efficiency considerations as it may well prove economically too costly to retire experienced workers early.

28

World Bank projections indicated that a joint PAYG/funded system could achieve a cash surplus of 0.5 percent of GDP in the year 2050, as compared to a deficit of one percent of GDP under an exclusive PAYG system.

29

In other words, the introduction of the funded pension pillar would imply a pension system deficit of 3-3.5 percent of GDP, higher than the targeted deficit of the consolidated general government under the Romanian Medium-Term Economic Strategy (MTES). Therefore, for the introduction of the private pillar to be consistent with the MTES, the remainder of the consolidated government would need to run a surplus of some 0.5 percent of GDP.

30

Some progress was made in reducing standard poverty measures in 1995 and 1996. (see OECD 1998) However, these proved to be as unsustainable as the output growth recorded in these years, and by 1998 poverty standards had again increased. Moreover, poverty became concentrated in households headed by low-wage earners and pensioners (see Pop and Tesliuc 2000). The latter trend suggests that the maintenance of low-value-added employment and the burdening of the pension system with social assistance tasks have failed to yield the expected poverty reducing outcomes.

31

For example, following a restructuring of the railways, an explicit budgetary subsidy (equivalent to 0.7 percent of GDP) was introduced in 1999. Previous subsidization of the railroads was hidden in their accumulation of payments arrears. However, there is evidence that this practice has not yet been entirely discontinued.

32

Absolute spending is at a roughly equivalent level to the Czech Republic, but higher than other countries, except Albania and the Slovak Republic.

33

In addition, the NBR also quickly accumulated substantial external debt, including, but not limited, to the Fund. From zero foreign indebtedness, the NBR had accumulated US$2 billion (7.3 percent of GDP) of external debt by 1996.

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Cover IMF Staff Country Reports
Romania: Selected Issues and Statistical Appendix
Author:
International Monetary Fund
Volume/Issue:
Volume 2001: Issue 016
Publisher:
International Monetary Fund
ISBN:
9781451832716
ISSN:
1934-7685
Pages:
223
DOI:
https://doi.org/10.5089/9781451832716.002
  • Figure II.1:
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    Figure II.1:

    Trends in Wage-Based Taxes, 1990-99

    (In percent of GDP)

  • Figure II.2:
    View in gallery
    Figure II.2:

    Trends in Statutory and Effective Wage Tax, 1992–2000H1

    (In percent)

  • Figure II.3.
    View in gallery
    Figure II.3.

    Romania: Indicators of Government Personnel Expenditure, 1990-99

  • Figure II.4.
    View in gallery
    Figure II.4.

    Romania: Pension System Indicators, 1990-2000

  • Figure II.5:
    View in gallery
    Figure II.5:

    Expenditure on Transfers and Subsidies, 1990-99

    (Excluding pensions, in percent of GDP)

Figure II.1:

Trends in Wage-Based Taxes, 1990-99

(In percent of GDP)
Figure II.2:

Trends in Statutory and Effective Wage Tax, 1992–2000H1

(In percent)
Figure II.3.

Romania: Indicators of Government Personnel Expenditure, 1990-99
Figure II.4.

Romania: Pension System Indicators, 1990-2000
Figure II.5:

Expenditure on Transfers and Subsidies, 1990-99

(Excluding pensions, in percent of GDP)