A. Introduction

57. Accession to the European Union presents Bulgaria with a unique opportunity to help speed up convergence to Western European living standards. Since abandoning central planning, Bulgaria has pursued closer institutional, trade, and financial integration with Western Europe in an effort to boost the economy’s performance and hasten convergence to EU living standards.³³ A key step in this process has been its goal of EU membership, which appears close to being realized. In order to help prepare for accession, Bulgaria has been receiving pre-accession financial assistance from the EU. Upon accession, which this chapter assumes will take place on January 1, 2007, the size of this assistance will increase significantly.

58. Upon accession, Bulgaria will receive substantial transfers from the EU budget. Reflecting its relatively low income, Bulgaria is eligible to receive larger EU transfers than the New Member States (NMS). Bulgaria is expected to draw funds averaging 3.6 percent of GDP annually during 2007-09.³⁴ After deducting annual contributions to the EU budget, the annual average net transfer to Bulgaria could be about 2½ percent of GDP (including both pre- and post-accession transfers). By comparison, the NMS are expected to draw on average 2 percent of GDP, according to Hallet and Keereman (2005), not adjusting for the EU budget contribution (which averages 0.9 percent of GDP for the NMS).

59. Although Bulgaria will be a net recipient of EU funds during 2007-09, the budget balance is most likely to be adversely affected. This is because there are additional budgetary effects from accession, including the contribution to the EU budget, co-financing requirements, and revenue losses stemming from lower customs and VAT collections. Estimates presented in this chapter suggest that the downward pressure on the fiscal position could amount to about 2½ percent of GDP on average in 2007-09. In these circumstances, and with external vulnerabilities expected to decline only gradually over the medium term, prudent fiscal policy will require finding partially offsetting measures.

60. The chapter focuses on three key questions:

• What is the direct fiscal impact of EU accession? Indirect (or second round) effects—such as positive fiscal effects due to higher growth—are beyond the scope of this study.

• What would be an appropriate fiscal stance, in 2007, given the answer to the above and the conjunctural outlook?

• What fiscal position should Bulgaria target over the medium term?

61. On the first question, the chapter concludes that, while significant, the fiscal impact of accession is manageable. First, the capacity to absorb EU funds is likely to be much less than projected, if experience in the NMS is a guide. ³⁵ And second, Bulgaria has the option to restructure its expenditure to make room for the new spending.

62. On the second question, an acceptable fiscal stance in 2007 would have to balance several competing objectives. On the one hand, external vulnerabilities are likely to remain high next year, so a substantial fiscal loosening relative to this year’s target is inappropriate. On the other hand, utilization of the EU funds should be maximized in order to facilitate convergence to EU living standards.

63. Beyond 2007, fiscal policy will need to remain cautious. Even in a benign scenario, external vulnerabilities—as measured by the external current account deficit and the gross external debt ratio—are expected to decline only gradually over the medium term. As a result, fiscal surpluses will be necessary to partially offset sustained private sector savings-investment imbalances, and to provide flexibility in case of cyclical downturns.

64. The plan of the chapter is as follows. The next section provides background on the EU financing instruments and the associated financial flows. Section C outlines the indicative EU financial packages for Bulgaria and the authorities’ estimate of expected utilization of the funds. The subsequent section assesses the overall fiscal impact and discusses the 2007 fiscal stance, while section E covers fiscal policy in the medium term. A final section offers concluding remarks.

B. Background

65. Membership in the EU entails a number of financial implications, both before and after accession. In order to assist accession candidates to carry out reforms required for membership, the EU provides three main types of financial instruments prior to accession: the PHARE, ISPA, and SAPARD programs (see Box 1).³⁶ Upon accession, new EU members start to participate in the system of fiscal transfers among the member states. On the one hand, they have to make annual contributions to the EU budget, while on the other they will have access to allocations from a number of funds: Structural Funds, the Cohesion Fund, and the European Agricultural Guidance and Guarantee Fund (EAGGF). In addition, accession countries have to co-finance EU structural operations from their national budgets, while the alignment of excise tax rates, VAT collection, and customs tariffs could result in net revenue losses. These various considerations are mapped out and explained in Box 1, while section C provides data for Bulgaria for the listed items.³⁷ The size of the pre- and post-accession transfers will depend on the institutional capacities of the new member states.

66. A number of studies have tried to quantify the likely fiscal impact of accession for the NMS. In general, an assessment of the fiscal impact of accession is complicated by the difficulty in pinning down a counterfactual (i.e., non-accession) scenario. While methodologies and estimated effects differ, the consensus appears to be that EU accession tends to weaken the acceding country’s fiscal position, to the extent there are no offsetting expenditure savings and/or revenue enhancements. Most of the NMS’ Pre-accession Economic Programs (PEP) contain estimates of the fiscal impact of accession. However, these estimates are difficult to compare as they are based on varying methodologies and depend on the size of the flows themselves. Some studies have looked at larger samples of countries. For example, Kopits and Székely (2003) estimate the direct effects for five NMS: Czech Republic, Estonia, Hungary, Poland, and Slovenia. They arrive at an estimate of a negative net budgetary effect of accession in the range of 3 to 4¾ percent of GDP. Antczak (2003) estimates that deficits will deteriorate by up to 3 percent of GDP in the first few years after accession. Backé (2002) foresees a somewhat lower negative impact of up to 1 percent of GDP.³⁸ A recent study estimates the net fiscal impact of accession for Romania at -0.9 percent of GDP (including only post-accession effects) in 2007 (see IMF (2006)).

67. In their work in this area, analysts at the EC argue that some of the studies for the NMS overstate the effects. Hallet (2004) states that “accession itself is not a very convincing justification for higher budget deficits in the new Member States after accession.” Indeed, Hallet and Keereman (2005) estimate the net budgetary effects to be positive, amounting to ½ percent of GDP for the NMS as a whole in the period 2004-06 (including pre-accession aid). In attempting to explain the different results, they view as decisive the question of whether accession related expenditure is considered to be additional spending or to be financed from a restructuring the budget.

C. The Indicative Financial Envelope and Expected Utilization of Funds

68. This section outlines the indicative financial envelope under the pre- and post-accession financial instruments. Since the actual utilization of EU funds is expected to be much lower, data on the latter are also presented.

Indicative Financial Envelope

69. Bulgaria has been receiving disbursements under the pre-accession financial instruments, and will continue to benefit from such flows until 2010.³⁹ On average during 2002-09, funds allocated for Bulgaria from the EU budget under these instruments is about 1 percent of GDP. Utilization of these funds—as measured by the ratio of funds disbursed (spent) to funds allocated—has been relatively high during 2002-05, at about 87 percent on average (not including co-financing). Going forward, pre-accession financing is expected to peak in 2007, and then gradually diminish before disappearing altogether in 2011 (not shown in table). The largest financing instrument in most years is PHARE, closely followed by ISPA.

Table 1.

Bulgaria: Pre-Accession Funds Allocated, 2005-09

(In millions of euros)

Sources: Bulgarian Ministry of Finance, May 2006; and IMF staff estimates.

Table 1.

Bulgaria: Pre-Accession Funds Allocated, 2005-09

(In millions of euros)

	2005 est.		2006		2007		2008		2009
	EU budget	Co-finance	EU budget	Co-finance	EU budget	Co-finance	EU budget	Co-finance	EU budget	Co-finance
Phare	99	24	135	25	250	54	205	66	36	20
ISPA	75	3	116	30	190	74	173	51	92	36
SAPARD	64	17	87	19	51	25	68	25	19	0
Total	238	45	337	75	491	153	447	142	147	56
Total (percent of GDP)	1.1	0.2	1.4	0.3	1.9	0.6	1.6	0.5	0.5	0.2

Sources: Bulgarian Ministry of Finance, May 2006; and IMF staff estimates.

View Table

Table 1.

Bulgaria: Pre-Accession Funds Allocated, 2005-09

(In millions of euros)

	2005 est.		2006		2007		2008		2009
	EU budget	Co-finance	EU budget	Co-finance	EU budget	Co-finance	EU budget	Co-finance	EU budget	Co-finance
Phare	99	24	135	25	250	54	205	66	36	20
ISPA	75	3	116	30	190	74	173	51	92	36
SAPARD	64	17	87	19	51	25	68	25	19	0
Total	238	45	337	75	491	153	447	142	147	56
Total (percent of GDP)	1.1	0.2	1.4	0.3	1.9	0.6	1.6	0.5	0.5	0.2

Sources: Bulgarian Ministry of Finance, May 2006; and IMF staff estimates.

70. In addition, Bulgaria is eligible for large transfers from the EU upon accession. The EU has committed ₤ 4.6 billion (2004 prices) in commitment appropriations to Bulgaria for the period 2007-09 (Table 2).⁴⁰

Table 2.

Bulgaria: Indicative Financial Package, 2007-09 1/

(Millions of euros, 2004 prices)

Source: European Commission.

^1/Commitment appropriations.

Table 2.

Bulgaria: Indicative Financial Package, 2007-09 1/

(Millions of euros, 2004 prices)

		2007	2008	2009	2007-09
Common Agricultural Policy		315	571	666	1552
	Market measures	132	129	127	388
	Direct payments	0	198	233	431
	Rural development	183	244	306	733
Structural Actions		539	759	1002	2300
Internal Policies		173	169	166	508
	Existing policies	88	89	91	268
	Nuclear safety	70	70	70	210
	Institution building	15	10	5	30
Compensation		122	59	59	240
Total Commitment Appropriation		1149	1558	1893	4600

Source: European Commission.

^1/Commitment appropriations.

View Table

Table 2.

Bulgaria: Indicative Financial Package, 2007-09 1/

(Millions of euros, 2004 prices)

		2007	2008	2009	2007-09
Common Agricultural Policy		315	571	666	1552
	Market measures	132	129	127	388
	Direct payments	0	198	233	431
	Rural development	183	244	306	733
Structural Actions		539	759	1002	2300
Internal Policies		173	169	166	508
	Existing policies	88	89	91	268
	Nuclear safety	70	70	70	210
	Institution building	15	10	5	30
Compensation		122	59	59	240
Total Commitment Appropriation		1149	1558	1893	4600

Source: European Commission.

^1/Commitment appropriations.

The package consists of ₤ 2.3 billion in structural actions (structural and cohesion funds, as discussed above), ₤ 1.6 billion for agriculture including rural development, ₤ 0.5 billion for internal policies, and ₤ 0.2 billion for budgetary compensation.

Expected Utilization of Funds

71. The authorities have projected the expected utilization of funds, given assumptions of absorption capacity. These estimates are summarized in Table 3 where they are expressed as a percent of GDP. Transfers of pre-accession funds are expected to remain significant at 0.9 percent of GDP in 2007, but then decline rapidly. Post-accession transfers are estimated at 1.5 percent of GDP in 2007, but are then expected to average 3½ percent of GDP in 2008-09 as the inflows of CAP subsidies, as well as absorption capacity, increase.

Table 3.

Bulgaria: Expected Utilization of EU Funds, 2007-09

(In percent of GDP)

Source: Bulgarian Ministry of Finance; IMF staff calculations.

Table 3.

Bulgaria: Expected Utilization of EU Funds, 2007-09

(In percent of GDP)

			2007	2008	2009	2007-09 Total
Pre-accession funds			0.9	0.5	0.2	1.6
	o/w PHARE		0.4	0.2	0.1	0.8
		ISPA	0.4	0.2	0.1	0.7
		SAPARD	0.1	0.0	0.0	0.2
Post-accession funds			1.5	3.4	4.1	9.1
	o/w EAGGF		0.1	1.7	1.8	3.6
		Structural Actions	0.5	0.9	1.5	2.9
		Internal Policies	0.7	0.7	0.7	2.2
Total pre- and post-accession funds			2.5	3.9	4.3	10.7

Source: Bulgarian Ministry of Finance; IMF staff calculations.

View Table

Table 3.

Bulgaria: Expected Utilization of EU Funds, 2007-09

(In percent of GDP)

			2007	2008	2009	2007-09 Total
Pre-accession funds			0.9	0.5	0.2	1.6
	o/w PHARE		0.4	0.2	0.1	0.8
		ISPA	0.4	0.2	0.1	0.7
		SAPARD	0.1	0.0	0.0	0.2
Post-accession funds			1.5	3.4	4.1	9.1
	o/w EAGGF		0.1	1.7	1.8	3.6
		Structural Actions	0.5	0.9	1.5	2.9
		Internal Policies	0.7	0.7	0.7	2.2
Total pre- and post-accession funds			2.5	3.9	4.3	10.7

Source: Bulgarian Ministry of Finance; IMF staff calculations.

D. Impact on the Fiscal Position

72. While the previous section outlined the scale and nature of EU funds available to the country as a whole, this section narrows the focus to the pure budgetary impact of EU accession. Thus, not all of the items listed in Box 1 and Tables 1-3 have budgetary consequences. In particular, of funds disbursed under the EAGGF, only those related to rural development would affect fiscal revenue and expenditure, while under “internal policies”, funds for nuclear plant decommissioning also do not flow through the budget.

73. The main budgetary implications of accession for the 2007-09 period are summarized in Table 4. Conceptually, the approach taken to assess the fiscal impact of accession is to add post-accession fiscal effects to a baseline that includes only underlying fiscal projections and pre-accession fiscal effects. The result is that the net negative impact of accession on the budget is 2.6 percent of GDP on average during 2007-09, absent offsetting fiscal measures. The following factors and considerations lead to this result:

Table 4.

Bulgaria: Net Budgetary Impact of EU Accession, 2007-09 1/

(In percent of GDP)

^1/Includes only post-accession effects.

Sources: Ministry of Finance; and IMF staff calculations.

Table 4.

Bulgaria: Net Budgetary Impact of EU Accession, 2007-09 1/

(In percent of GDP)

		2007	2008	2009
Net transfers to National Budget		0.0	1.0	1.9
	Receipts from EU budget (+)	1.3	2.2	3.1
	Contributions to EU budget (-)	1.2	1.3	1.2
Other factors		-2.6	-3.6	-4.4
	Project spending (EU financed)	-1.1	-1.8	-2.8
	Cofinancing	-0.3	-0.5	-0.6
	Indirect revenue impact	-1.2	-1.3	-1.1
	Net impact on budget	-2.6	-2.6	-2.5

^1/Includes only post-accession effects.

Sources: Ministry of Finance; and IMF staff calculations.

View Table

Table 4.

Bulgaria: Net Budgetary Impact of EU Accession, 2007-09 1/

(In percent of GDP)

		2007	2008	2009
Net transfers to National Budget		0.0	1.0	1.9
	Receipts from EU budget (+)	1.3	2.2	3.1
	Contributions to EU budget (-)	1.2	1.3	1.2
Other factors		-2.6	-3.6	-4.4
	Project spending (EU financed)	-1.1	-1.8	-2.8
	Cofinancing	-0.3	-0.5	-0.6
	Indirect revenue impact	-1.2	-1.3	-1.1
	Net impact on budget	-2.6	-2.6	-2.5

^1/Includes only post-accession effects.

Sources: Ministry of Finance; and IMF staff calculations.

• Payments from the EU budget and corresponding expenditures. In general, the post-accession funds that become available on January 1, 2007 are tied to particular programs or projects, so that the net effect on the budget should be approximately zero (abstracting from co-financing requirements, discussed below). However, since there are timing differences in some cases between project spending in the Bulgarian budget and receipt of funds from the EU, there may be a temporary net impact on the fiscal balance measured on a cash basis.⁴¹ In addition, the “receipts from EU budget” line includes the special cash transfer (about 0.2 percent of GDP). For 2007, receipts from the EU budget total 1.3 percent of GDP, and grant-financed spending is 1.1 percent of GDP.

• The contribution to the EU budget. The contribution to the EU budget contains the items listed in Box 2. The contribution Bulgaria has to make is 1.2-1.3 percent of GDP annually in 2007-09.

Box 2.

Contribution to the EU Budget

• 

  

  View Expanded

  
  Traditional own resources. These are composed of (i) agricultural levies; and (ii) customs duties collected on imports from non-member states. Member states pass 75 percent of their collections of customs duties to the EU budget, and retain the remainder.

• 

  

  View Expanded

  
  VAT-based resources. This is derived from the application of a uniform rate to the VAT assessment base for the member.

• 

  

  View Expanded

  
  GNI-based resources. This is a variable topping up resource to help cover the EU’s payment appropriations. It is the largest revenue source for the EU budget.

• 

  

  View Expanded

  
  UK rebate. The UK negotiated a rebate on its payments to the common budget. This rebate is financed by all the other EU members.

Box Table 1.

Bulgaria: Contribution to EU Budget, 2007-09

(In millions of BGN)

Source: Bulgarian Ministry of Finance; IMF staff estimates.

Box Table 1.

Bulgaria: Contribution to EU Budget, 2007-09

(In millions of BGN)

	2007	2008	2009	2007-09
Traditional own resources	180	180	180	540
VAT-based resources	82	93	101	276
GNI-based resources	335	382	415	1,132
UK rebate	37	42	46	125
Total (Percent of GDP)	1.2	1.3	1.2	3.1

Source: Bulgarian Ministry of Finance; IMF staff estimates.

View Table

Box Table 1.

Bulgaria: Contribution to EU Budget, 2007-09

(In millions of BGN)

	2007	2008	2009	2007-09
Traditional own resources	180	180	180	540
VAT-based resources	82	93	101	276
GNI-based resources	335	382	415	1,132
UK rebate	37	42	46	125
Total (Percent of GDP)	1.2	1.3	1.2	3.1

Source: Bulgarian Ministry of Finance; IMF staff estimates.

• Co-financing requirements. EU structural assistance finances less than the total cost of a program or project, which means that national co-financing is required, aimed at providing incentives for efficient use of such funds.⁴² The maximum EU contribution is 75 percent of total public project (or program) spending, but there are exceptions, so that the co-financing requirement is typically in the 20-25 percent range. The cost for Bulgaria of co-financing is projected at 0.3 percent of GDP in 2007, doubling to 0.6 percent by 2009.

• Revenue losses from lower customs collections and lower VAT efficiency. Upon accession, border controls between Bulgaria and the EU will cease to exist. Hence, imports from the EU will no longer be subject to import duties. In addition, 75 percent of those duties collected on imports from non-member states accrues to the EU budget (part of the contribution to the EU budget, under traditional own resources), leaving 25 percent as a “fee” for such collections. Similarly, VAT collection on imports from EU member states will no longer be collected by customs offices; upon accession, such collections will be handled domestically by the National Revenue Agency. The room for evasion and fraud in that case is greater than under the current system, and some losses in VAT collections are therefore to be expected.⁴³,⁴⁴ The authorities project the revenue loss to be around 1.2 percent of GDP, although there is a large margin of uncertainty around this estimate.

• Revenue gains from the harmonization of excises. Bulgarian excise rates on alcoholic beverages are being raised to EU minimum levels, and excise rates on tobacco and fuels also continue to be raised. From 2007, Bulgaria will levy excises on electricity, coal, and coke. The EU has allowed members (and prospective members) a long period of transition to these higher rates. Bulgaria began raising excise rates in 2002 and has until end-2013 to complete this schedule.⁴⁵ Any revenue gains from higher excises are already included in the baseline fiscal projection, since the schedule has been known for some time.

• Additionality requirement. In general, pre-accession aid, structural funds and rural development transfers are subject to the additionality requirement whereby EU transfers may not substitute existing expenditure. However, the EC has generally taken a flexible approach, in part because it is difficult to verify whether this requirement has been met.

2007 Fiscal Stance

74. It is clear from the foregoing that, absent offsetting spending cuts or new revenue measures, EU accession will be accompanied by a sizeable fiscal impulse. Staff calculations suggest that in 2007 the general government surplus would decline to 1.4 percent of GDP, a substantial easing from the projected 3.2 percent surplus in 2006 (Table 5). This result is derived by adding to projected revenue and expenditure baselines—which include underlying fiscal projections and estimated pre-accession effects—the post-accession effects. On the revenue side, accession has a neutral effect, as post-accession grants (including the special cash transfer) are offset by revenue losses. Hence, revenue-to-GDP remains at 39.6 percent of GDP. On the expenditure side, accession adds 2.6 percent of GDP in new spending, raising the expenditure ratio to 38.2 percent of GDP.⁴⁶

Table 5.

Bulgaria: 2007 Fiscal Projection

^1/Includes BGN 476 m. in preaccession grants.

^2/Includes BGN 652 m. in preaccession spending.

Source: Ministry of Finance; and IMF staff calculations.

Table 5.

Bulgaria: 2007 Fiscal Projection

				Millions of leva	Percent of GDP
Baseline revenue, excl. postacc.-related				20,251 1/	39.6
plus:
	Post accession grants			641	1.3
	Indirect effects			-638	-1.2
	Total			3	0.0
Final revenue				20,254	39.6
Expenditure baseline, excl. postacc.-related				18,207 2/	35.6
plus:
	Post accession spending			1,324	2.6
		of which:
			cofinancing	78	0.2
			agri top up	55	0.1
			project spending	556	1.1
			contribution to EU budget	634	1.2
Expenditure				19,531	38.2
Balance excluding expenditure savings				723	1.4
Expenditure savings				-298	-0.6
Final expenditure				19,233	37.6
Overall balance, including EU effects				1,021	2.0

^1/Includes BGN 476 m. in preaccession grants.

^2/Includes BGN 652 m. in preaccession spending.

Source: Ministry of Finance; and IMF staff calculations.

View Table

Table 5.

Bulgaria: 2007 Fiscal Projection

				Millions of leva	Percent of GDP
Baseline revenue, excl. postacc.-related				20,251 1/	39.6
plus:
	Post accession grants			641	1.3
	Indirect effects			-638	-1.2
	Total			3	0.0
Final revenue				20,254	39.6
Expenditure baseline, excl. postacc.-related				18,207 2/	35.6
plus:
	Post accession spending			1,324	2.6
		of which:
			cofinancing	78	0.2
			agri top up	55	0.1
			project spending	556	1.1
			contribution to EU budget	634	1.2
Expenditure				19,531	38.2
Balance excluding expenditure savings				723	1.4
Expenditure savings				-298	-0.6
Final expenditure				19,233	37.6
Overall balance, including EU effects				1,021	2.0

^1/Includes BGN 476 m. in preaccession grants.

^2/Includes BGN 652 m. in preaccession spending.

Source: Ministry of Finance; and IMF staff calculations.

75. Against the backdrop of domestic demand pressures and external vulnerabilities highlighted in the Staff Report, a substantial fiscal easing would be inappropriate for macroprudential reasons. At the same time, some degree of fiscal easing is inevitable if use is to be made of the EU grants, and recognizing the budgetary impact of the contribution to the EU budget and the revenue losses accompanying accession. After weighing these competing considerations, a 2 percent of GDP surplus in 2007 appears to be an appropriate objective. Achieving this goal, given the impact of accession outlined in Table 5, would necessitate expenditure saving/substitution of 0.6 percent of GDP. Part of these savings could be achieved by funding existing projects with EU rather than national grants.⁴⁷ Expenditure savings rather than revenue measures would be the preferred method of adjustment, in line with the government’s fiscal objectives.

76. A prudent fiscal stance is also justified by the uncertain broader macroeconomic impact of accession. The large-scale grants from the EU should boost aggregate demand and output in the economy, without raising external debt. However, it is likely that the demand effects will exceed the supply effects in the short run, adding to overheating pressures. In the long run, the supply effects will probably dominate, and facilitate a shift to a higher growth path.

E. Fiscal Policy in the Medium Term

77. Beyond 2007, the challenges for fiscal management will continue to be substantial. As Table 4 shows, the negative impact on the fiscal position remains around 2½ percent of GDP in 2008-09. A number of factors—in addition to those related to EU accession that have been explored already—need to be considered when determining an appropriate medium-term fiscal framework for Bulgaria. On balance—while they do not provide quantitative guidance on the desirable medium-term path of the budget balance and debt levels—the considerations below seem to suggest that small medium-term fiscal surpluses are advisable:⁴⁸

• Public debt sustainability. Public debt has been reduced substantially in recent years. Public debt stood at just below 32 percent of GDP at end-2005, less than half of its recent peak of 70 percent in 2001. This reflects both large primary surpluses and sizeable buybacks of external public debt financed by large-scale privatization. On current projections, public debt should decline to just under 19 percent of GDP by 2011. Schadler et al (2005) suggest that a prudent public debt ratio for Central European countries might be around 45 percent of GDP, so on this yardstick alone, there appears to be no conceivable reason for future surpluses.

• Macroeconomic conditions. The large private savings-investment imbalances of the last few years are expected to persist into the medium term, despite a projected increase in private savings. There will therefore remain an important basis for the public sector to provide a partial offset. Moreover, fiscal policy will remain the principal tool for managing adverse cyclical conditions; a prudent fiscal policy stance and low public debt would provide room for countercyclical fiscal stimulus, including by allowing automatic stabilizers to operate.⁴⁹

• Structural fiscal pressures. On the one hand, Bulgaria’s tax policy remains focused on cutting direct taxes (including payroll and corporate taxes) and aligning its tax legislation with EU standards. On the other hand, the country faces large demands on both current and capital public expenditure in the future, subject to a 40 percent of GDP public expenditure ceiling set by the current government. While the impact of the tax policy changes may over time be revenue neutral or even positive, the expenditure demands will need to be accommodated within the 40 percent ceiling, which is already essentially binding. The spending demands are expected to be largely in the infrastructure, health, and education sectors.⁵⁰ In addition, the substantial aging of Bulgaria’s population over the next several decades will potentially place mounting demands on the budget.

• The desired/optimal size of government. At a spending level of 40 percent of GDP, a prudent fiscal stance would require a revenue ratio slightly in excess of 40 percent. This implies a sizeable tax burden on the private sector, which distorts incentives and reduces economic efficiency. Moreover, a recent World Bank (2005) study finds that, at an average of about 39 percent of GDP (excluding budgetary social security contributions) in 2000-04, spending is about 3 percent of GDP higher than predicted by a simple model that relates GDP per capita growth to the level of expenditure.

F. Concluding Remarks

78. Accession to the EU presents Bulgaria with a one-time opportunity to underpin the longer-term goal of convergence with Western European living standards. The EU transfers that become available upon accession—in addition to the pre-accession transfers already in the pipeline—will free up resources for spending in growth- and productivity-enhancing areas such as human resource development and infrastructure. But there will also be additional demands on Bulgaria’s budget, including mandatory contributions to the EU budget, co-financing obligations, and revenue losses from lower VAT collection efficiency and from loss of customs revenue from imports originating in the EU. These demands will need to be carefully managed lest accession provides an excessive demand stimulus at a time of persistent overheating pressures.

79. Fiscal management will be particularly tested in 2007, the assumed year of accession in this chapter. While there remain uncertainties regarding the eventual direct financial flows and other accession-related budgetary effects, staff estimate that the negative budgetary impact of accession is about 2½ percent of GDP, absent offsetting measures. Given underlying fiscal projections and pre-accession effects, this would result in a surplus of 1.4 percent of GDP, an excessive easing from the projected 3.2 percent surplus in 2006. Expenditure savings/substitution—which could partly be achieved by directing EU funds towards projects that are currently nationally funded—of about 0.6 percent of GDP could bring the surplus to a more acceptable level of 2 percent of GDP.

80. The fiscal impact of accession will remain sizeable in the medium term as well. Expenditure restructuring will therefore continue to be required. While public debt sustainability is not an issue, the need for fiscal buffers in the future and underlying spending pressures argue for small fiscal surpluses in the future.

81. Bulgaria should look to the experience of the EU15 and the EU8 in order to make effective use of the EU grants. Meth-Cohn and Shields (2005) offer four main lessons in this regard:

• Develop a clear strategic vision at all levels of government.

• Encourage public-private partnerships to ensure high quality and commercially viable projects while promoting public sector objectives, on condition that supporting legal conditions are in place.

• Ensure municipal involvement in the projects.

• Take into account the inherent inflexibility of EU funds.

Overall, Bulgaria will need to (1) ensure a high degree of absorption capacity while carefully directing the EU funds to projects that enhance the economy’s productive potential and (2) enhance its ability to align national spending priorities better with those under EU programs by substituting certain national expenditure with EU payments. In this context, the recent criticism by the European Court of Accounts regarding the manner in which PHARE-funded projects were implemented in Bulgaria and Romania suggests there is scope for improvement in the utilization of EU funds.