Sunday, February 11, 2007

ROMANIA: BUDGET GAP WIDENS FOR EU ENTRY

Budapest Business Journal (BBJ) reports that Romania's state budget deficit widened to 1.7% of GDP last year from 0.8% in 2005 as spending increased before the country joined the European Union. In 2006, the country was forced, by the EU, to launch an expansionairy fiscal and budget policy, closely related to Keynesian economic doctrine based on consumption and spending (instead of incentives) stimulations. Tight EU regulations forced the country to widen the budget gap as the policymakers in Brussels set several requirements which Romania probably had to adjust. Among them, spending on pensions several other areas, including infrastructure, was introduced. The government plans to raise spending more this year, widening the budget deficit to 2.8 percent of the GDP. As late as November, Romania posted a budget surplus of 1.2% of GDP. Budget balance should be narrowed in order to avoid long-term accelerating inflation from a 16-year low of 4,7 percent. It is highly recommendable for the Central Bank to follow the rules instead of discretion. It could set the inflation targeting framework and thus make a commitment and minimize the inflation risk which is a first-degree priority for further price stability. Transparent and non-complex tax code, instituted by a 16 percent flat tax, did not cause the instability of public finance as policymakers in Paris and Brussels have predicted. Instead, the flat tax generated more revenue, from 30,3 percent in the previous year to 31,8 percent in the last year.

EU Monetary Affairs Commissioner Joaquin Almunia said last year that "budget revenue as a proportion of GDP was lower than in any EU nation and recommended the country increase it." Following the empirical evidence, raising tax rates and penalties on productive behavior will not result in higher revenue. High taxes, instead of revenue-neutral tax rate, cause high administration costs. Numerous loopholes, deductions and exemptions stimulate individuals to search devices of how to avoid paying taxes. Tax collection thus becomes very costly while at the same time, tax revenue can hardly reach higher levels.

Laffer Curve shows this particular aggregate relationship between tax rates and the height of tax revenue. Laffer Curve in the case of Romania goes following:
"Romania has said income tax revenue has consistently increased since January 1, 2005, when it introduced a flat tax of 16% on corporate and personal income, the lowest in eastern Europe. It replaced a corporate tax rate of 25% and a personal income tax rate of as high as 40%. The Finance Ministry said revenue from the 19% value added tax increased 23% last year and totaled 8.3% of GDP and customs tax collection rose 19%."

The surest way to increase the revenue is to lower tax rates on corporate and individual income and set them flat. Another very important way to raise the revenue is to work on monetary stabilization and price stability. Cutting penalities on productive behavior is of the utmost importance as well. There is no such thing as a static feedback between productive behavior and tax system. Expansionairy spending could strongly boost the public consumption in the long-run when the stability of the public finance could pose serious risk if policymakers pursued a spiral of spending mechanism with high public debt and structural weakness.

4 comments:

Prodromos said...

Can you post some evidence regarding a flat tax system that has led to increases in tax receipts? I seem to have read the contrary for Russia, but I don't have the link handy and I would love to see some evidence.
Flat tax is not a bad idea, but, more than just inequitable, it's absolutely pathetic to apply it to environments where there are lots of consumption/non-income taxes such as most EU countries.
For example, in the UK we pay a fixed sum of about €1000 per year in municipal tax, 80% tax on fuel and tobacco, 35% tax on alcohol, €200 per year in TV tax, €280 per year in car-tax, 20% interest tax on savings (without any allowance for inflation!). Even without a flat income tax rate, this regime means that the wealthy pay a SMALLER percentage of their income as tax than the poor.
I like your thoughts about the free market, stimulating enterprise and so on, but thus far the practice is to liberalise the capital market (through tax competition, lower duties/fewer tariffs) while keeping labour tied to their country/region of birth, resulting in a disgusting outcome that gives capital an unfair advantage both against labour and states....

Prodromos said...

And obviously there is no mention of VAT in the above post...
Within a country, of course, everyone pays VAT and indeed at the same percentage rate, so, while it hurts the poor a bit more, it is not totally stupid like the €1000 municipal tax and its ilk.
But the wealthy can spend large amounts of cash without worrying about it through buying the latest Rolex during a fun weekend in Dubai or spotting an ultra-light laptop at an electronics shop while wandering around Hong Kong after the meeting with their "Asian High-Net-Worth Client Consultant".
In the process they take away VAT, local taxes, and often even the jobs of people in their home country. This I don't really care about (indeed I take advantage of it myself!), but a flat tax regime which expands exactly this kind of "disposable income" nicely adds insult to the (economic) injury experienced by the rest of the society, who will not be in the position to save on VAT by making big purchases coincide with (leisure/business) trips to tax free destinations.

Rocks said...

Hi,

Thank you for thorough posts.

Regarding your wish, I'll post a longer piece (I hope that still today), giving evidence to the relationship between dynamic tax system and the increase in tax revenue. And on VAT as well.

Flat tax has been increasingly modified by tax policymakers. Iceland, for example, is known for the recent tax reform that instituted a single flat tax on individual income but it's not purely Hall-Rabushka since there's a bulk of exemptions and deductions remained left. So it depends on which version of the flat tax you want to impose. Negative income tax is a direction application of tax system to consumption tax instead of taxing your income. It is far more efficient and fair as numerous empirical studies have given such evidence (Hall, Friedman, Rabushka, Kotlikof, Feldstein, Stokey, Rebello...).

It's a mistaken belief that flat tax is a solution for just about everything. Flat tax is a way in the right direction but systematic features are still needed. Among them, the liberalization of capital markets, the flexibility of the labor market and the liberalisation of international trade etc.

Politicians prefer to neglect the economic impacts of a stimulating tax reform because they're simply concerned with revenue instead of taking care to apply the institutional environment favorably to the business environment and economic growth in general. In a modern, dynamic economy, human capital is the main driver of economic growth (see: Lucas). When tax rate progressively punish the productive behavior, human capital creation is less profitable and more risky. Greater accumulation of human capital is a requirement for higher economic growth while cutting taxes and liberalizing the structural environment are the foremostly efficient way to let the innovation, competitiveness and growth flourish.

Enjoy the rest of the day.

Regards,
Rocks

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