23 November 2010, 22:36 by aathanor
Very useful analysis.
IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Romanian government took recently more and more controversial measures. Many of them are officially presented as a consequence of the economic and financial global crisis. Actually, they are the consequence of ill-conceived, poorly-explained and incoherently applied fiscal reforms. We have presented elsewhere some of the problems faced by Romania during its transition (see the reports for Romania in IREF’s yearbooks on taxtion). We will here limit ourselves to problems related to current budgetary difficulties. In short, Romania’s deficit is the result of many errors on the expenditure side as well as on the revenues side of its consolidated budget. Similar errors are still made today.
When Romania adopted the Fiscal Code (2003) and the flat tax at 16% on personal and corporate income tax, Romanian entrepreneurs and taxpayers in general, along with foreign investors, had strong reasons to be optimistic about the future of taxation in this country. The following deception matched an optimism proved unjustified. Simplification remains a goal more than a reality, because the flat tax as implemented in Romania allows for so many exceptions. Clarity is not yet achieved, despite the fact that the size of the Fiscal Code has almost doubled. The mild taxation suggested by the low tax rate is an illusion, because of the high level of social security tax rates. Moreover, fiscal instability – which represents a major and underestimated component of the fiscal burden – is still the rule in this country. Contrarily to explicit and implicit political promises of fiscal stability and despite the fact that it violates the Fiscal Code, successive governments, supported by virtually all parliamentary parties, have introduced changes in the fiscal rules to be applied the same fiscal year and, often, by the means of emergency ordinances. Since its first adoption in 2003, Fiscal Code was amended about 80 times (finding the exact number of modifications is actually a real challenge). In 2010, between 1st January and October 31st, the Fiscal Code was already amended 13 times. Moreover, most of these changes violate article 4 of the Fiscal Code, which stipulates that the Code can be amended “only by law, usually adopted 6 months before the enforcement date. Any [amendment] of this Code becomes operational starting with the first day of the year after [the amendment’s] promulgation”.
This article presents briefly the most important changes in Romanian taxation that took place between end of June and 31st October of 2010.
23rd June 2010
Romanian Government decided to amend the Fiscal Code by an emergency ordinance (No 54/2010) “concerning some measures against tax evasion”. In Government’s opinion, there are many reasons to ignore the law (article 4 of the Fiscal Code) and those reasons are carefully presented at the very beginning of the ordinance: “… the necessity to fight VAT evasion under a regime of maximum emergency (…), to increase the degree of collecting budgetary revenues (…)” underlying that “these elements concern the general public interest and constitute emergency situations, which must be solved without delay.” It is hard to believe that, a year ago, VAT evasion and collecting budgetary revenues weren’t a problem yet and, sometimes during the last year, they became an emergency problem… In any case, the government granted about one month to companies (until 28th July 2010) to comply with the new rules.
Some of these rules concern businesses involved in “intracommunautaire” trade, businesses involved in production or trade with excisable products and duty free-shops. The ordinance does not increase tax pressure in a direct way, but it increased opportunity costs for businesses (it eliminates the possibility of excise suspension in the case of goods’ transportation between two fiscal warehouses, it increases or requires new warranties for some operations involving excisable goods etc.) Hence, the ordinance increases administrative burden. Enterprises involved in intracommunautaire trade are required to ask for registration in the Register of Intra-communautary Operators, to be created on August 1st, 2010. They must provide many documents in order to register, most of them delivered by public authorities. The ordinance also increases legal risks for entrepreneurs and employees (higher fiscal fines, joint fiscal liability, etc.).
26th June 2010
Only three days later, Romanian Government found new reasons to amend the Fiscal Code with an Emergency Ordinance (58/2010) showing the same lack of concern about article 4 of the Fiscal Code. Surely, in three days Fiscal authorities had acquired new knowledge about Romania’s economic and budgetary situation so that what was not known or not quite sure on June 23rd became an obvious national emergency on 26th. As explained by the Government, “because budgetary revenues were profoundly affected by the economic and financial crisis, and in order to ensure an equilibrium between revenues and spending levels (…), to enlarge the tax base and to increase some [direct and local] taxes, in order to eliminate some incompatibilities between national legislation (…) and article 49 of EU Treaty (…) and because [without these modifications, Romania will face] the negative consequences of budgetary deficit.”
The most visible measure of E. O. No 58 was undoubtedly the sharp increase in VAT rate, from 19% to 24%; very close to the maximum level allowed by EU treaties. In 2009, a VAT increase was explicitly excluded by all relevant political parties, which was understandable in an electoral year, but ambiguity surrounded this measure during 2010. The VAT increase had to come in effect only after a couple of days, on July 1st 2010. One can only imagine the compliance costs generated by such a short delay. The modification of one of the most important taxes in less than a week destroyed probably the little credibility that Romanian fiscal authorities were still enjoying.
But Emergency Ordinance No 58 changed many other things. For instance, it increased the taxation of personal copyright revenues and “any other revenues of professional nature”. Formerly, personal copyright revenues were taxed at 16% of taxable income (gross income minus a deductible expense established at 40% of gross income) and totally exempted from social contributions. This Ordinance reduced the percentage of deductible expense at 20% and introduced the obligation to pay social security contributions on copyright revenues. However, the tax base for social security contributions is limited to five gross average salaries. The previous tax regime made “copyright contracts” a very popular tool among those who wanted to avoid social security taxes. Employee’s contributions (10.5 %) cumulated with the so-called employer’s contributions (20.8%) represent 31.3% on gross revenues for employees with a regular labor contract, under normal working conditions. The total social tax rate for social contributions is 36.3% for uncommon working conditions and 41.3% for special working conditions. Beside the fact that social contributions are among the highest in Europe, the benefits are hypothetical (public pension in current PAYG system) or hypocritical (the gratuity of medical services is an illusion shared only by those who never needed medical services).
Fiscal reform of 2005 – which introduced, among other things, the flat tax – maintained this loophole to the benefice of writers and other artists, inventors, journalists etc. There are at least two reasons to be skeptical about such exceptions. First, form an ethical point of view, it is debatable why some professions should have privileges and which criteria to use for establishing their list. As a practical matter, it is very likely that any proposal for a special tax regime would generate endless debates. The second reason follows: according to Public Choice theory, any exemption will generate rent seeking and lobbying activities to extend it to other professions.
This process generates unpredictable changes and arbitrary distortions. The only conceivable reason for the introduction of “meal certificates”, “holiday certificates”, “gift certificates”, “kindergarten certificates” and the like was the possibility to avoid social security taxes for the amount of these certificates. This legal tax avoidance was accessible only to firms over a certain size, which could afford the corresponding supplementary administrative burden. A similar result for the employees and employers’ points of view could be obtained by a reduction in social security tax rates. This latter solution would be accessible to all firms and employees and would imply a lower administrative burden. Ordinance 58 eliminated this dilemma because it included meal, holiday, gift and kindergarten certificates in the tax base for social security contributions…
Besides, Emergency Ordinance No 58 increased uncertainty and potential arbitrary from fiscal authorities. According to its first article, “any activity can be reconsidered as a dependent activity” if it fulfills at least one of six criteria, the last of them being “any other elements that reflect the dependent nature of the activity”. Of course, the reconsideration implies the recalculation of income tax and social contributions. This means that a copyright contract (like, for example, those of some journalists) can be reconsidered as a regular labor contract, which will increase significantly social contributions.
Also pursuant to E. O. No 58, and starting July 1st, 2010, the 16% income tax will be extended to all types of interest income, hence closing some loopholes existing previously. For example, interests on saving accounts were previously tax exempted. Of course, the interest income is taxed on nominal terms, regardless of the inflation level. In 2010, interests on deposits and saving accounts were around 7 – 7.5%, but the inflation rate targeted by the central bank is 3.5% (±1%) for 2010, while current inflation rate reached 7.77% (Sept 2010 to Sept. 2009). Therefore, depositors are expropriated twice: first, by a negative interest rate and a second time by a tax on a non-existing income.
But that’s not all. The tax rate on dividends paid to corporations increased from 10% to 16%. (Dividends are not taxed when paid by a Romanian corporation to another Romanian corporation and the beneficiary holds 10% of payer’s capital for a minimum of two years). Therefore, the tax rate on dividends paid to corporations became equal to the tax rate for dividends paid to individual stockholders. In a way, this seems to be a step towards a unification of tax rates and towards the elimination of distorting exceptions. However, exceptions are still in place and the simplification is only marginal. Moreover, from the individual stockholder’s point of view, the income of the capital factor is taxed twice: once as a corporate income and a second time as a personal income (contrary to what is done in Slovakia, for example, where corporate income is taxed only once).
Finally, personal income tax rate on gambling increased by extending the 25% rate to the lower bracket that was taxed previously at 20%. Gambling was subject to a progressive taxation with two brackets (20% and 25%). E. O. No 58 extended the 25% tax rate to all gambling income levels. In a way, this means that the flat tax applies also to gambling incomes…
30th June 2010
A new Emergency Ordinance (59/2010) was obviously necessary to amend the Fiscal Code just two days after the previous one. The reasons enumerated in its preamble are almost identical in both ordinances (58 and 59). The only significant difference is that the need to eliminate incompatibilities between national and EU regulations is replaced with a reference to the necessity “to fulfill Romania’s obligations resulting from treaties with international borrowing organizations, absolutely necessary in order to finance public spending and to maintain investors’ trust into Romanian socio-economic environment”. It seems that, sometimes between 28th and 29th June 2010, Romanian government identified the risk to lose investors’ trust, and that the best way to keep it was to change again the Fiscal Code.
The first article of E. O. 59 modified article 252 of Fiscal Code. It increased real estate tax rates applied to physical taxpayers and accentuated their progressiveness – a rather bizarre mean to maintain investors’ trust. Every real estate owner has to pay a real estate tax, established according to the fiscal value of their property. However, this tax increases with the number of residences. Owners of more than one residence will have their regular real estate tax increased for the first (65%), second (150%), third and more (300%) houses (apartments, buildings), putting aside the main residence. These percentages were previously 15%, 50%, 75% and 100% for the first to the fourth residence, aside the main residence. The order of the buildings and therefore the corresponding percentages depend on the date of acquisition. Inherited houses are exempted. This modification became operational in the second half of 2010 and it concerns even taxpayers who already paid in advance all the real estate tax due for the current year. Basically, on June 30th, some taxpayers were informed that their real estate taxes will increase the next day. It’s doubtful that this led also to an increase in investors’ trust.
Although these taxes are revenues for the local authorities, their general frame is decided at the national level, in the Fiscal Code. The tax depends on the fiscal value of the building, calculated according to a matrix with about 8-10 criteria.
8th September 2010
The Emergency Ordinance du jour (82/2010) modifies not only the Fiscal Code but also another Emergency Ordinance (58/2010) which itself modified the Fiscal Code two months and half earlier. This time, the modifications were recommended by the “international financial organizations [in order to maintain] social security budget’s sustainability”.
Actually, this very brief ordinance seems to be the result of a lobby campaign because it allows exceptions and exemptions of social security contributions for some categories of taxpayers. For example, “persons who, along with salaries, occasionally earn incomes of professional nature” are exempted of social security contributions for those extra incomes. That concerns mainly but not exclusively, opinion leaders (journalists, artists, etc.) who were strongly opposed to ordinance 58.
29th September 2010
The Emergency Ordinance No 87/2010 abolishes the minimum corporate income tax introduced in 2009. This was one of the most unpopular taxes, with a devastating effect on Romanian economic environment but a limited impact on collected taxes. Its suppression comes in effect on October 1st, 2010, in conformity with government’s promises – a fact worthy of attention.
The other good news is that the ambiguous expression “any other elements that reflect the dependent nature of the activity” was removed from the list of criteria that allow fiscal authorities to reconsider an economic activity as a dependent one.
23rd October 2010
This is the most recent example of fiscal instability offered by Romanian authorities. The Parliament voted unanimously a VAT reduction from 24% to 5% for food and an increase of the income tax-exemption of pensions from 1000 to 2000 lei/month (about 465 Euros). Both measures are very hard to make sense of. The first one came after an overall increase of the VAT (from 19% to 24%), just four months ago, by the same government and parliamentary majority, in order to keep the deficit under the limits agreed with the IMF. The second measure is even more puzzling because the tax-exempted pension (2000 lei / 465 Euros) is superior to the average pension (714 lei / 166 Euros in July 2010) by 160% and superior even to the net salary (1355 lei / 315 Euros in July 2010) by almost 50%. For the consolidated budget, the estimated cost of these measures is about 500 million Euros. The next day, the government and its parliamentary majority declared that the law was voted “by mistake” and that they will try to abrogate these measures. Maybe they planned to “correct” the error before the vote on the non-confidence motion initiated by opposition parties for October 27th, but they didn’t. The non-confidence motion didn’t pass, but the aforementioned error is not yet corrected.
Romanian government explains that all the previous measures are a direct consequence of the economic and financial crisis. The truth is that successive Romanian authorities have a huge part of responsibility for the current situation. Public spending increased (much) faster than GDP. From 2000 to 2008, Romania’s benefited from continuous economic growth, stopped only by the current global crisis. From a fiscal point of view, past errors are followed by current ones.
Not surprisingly, at the end of communism, public sector was dominant and government involvement in economic and social life was overwhelming. It took about a decade for the private sector to overpass the public sector. It took much longer for the successive governments to eliminate subsidies and to reduce its costly involvement in different sectors like mining, energy, railway, banking, pension and medical systems.
Today, pensions represent a major component of Romanian public spending for at least two reasons. First, after 1990, birth rate dropped by about 50% and remained at a very low level (about 10 per thousand) and mortality rate increased and later decreased slightly, but remained inferior to natality rate. These demographic tendencies resulted in two decades of negative natural increase in Romania’s population. Second, early retirement as retirement for real or fictional medical reasons were massively used as political tools for hiding unemployment. According to National House of Pensions and Other Social Insurance Rights and, respectively, National Institute of Statistic, in July 2010, Romania had 5.497 million pensioners and 4.248 million employees, for a total population of 21.2 million. Successive governments tried to correct some incoherencies and injustices, which resulted in an increase in the number of beneficiaries and/or of the pensions. Any attempt to reduce “special pensions” of the privileged categories was blocked by the courts.
Since 2001, Romanians are entitled to a minimum income, among other social aids (like heating subsidies). The total cost of the program is about 175 million Euros for 2010. The individual level of the minimum income is not very high (about 25 Euros) but it generates administrative costs and incentive distortions. According to the Ministry, after a verification of about half of the applications, 25% of minimum income beneficiaries didn’t fulfill current legal requirements. The crisis forced the government to reconsider this program (only in 2010) and to propose stricter conditions. The changes are supposed to be enforced only in 2011.
As a result of successive deficits, Romanian public debt has doubled since 2007. End of August 2010, its level reached 35%, compared to 30% at the end of December 2009. All tax increases decided this year and spending cuts such as the 25% cut on public employees incomes suggest government’s concern about the current situation. But in the same time they are signs of despair and improvisation; not of a desire to follow a coherent and effective fiscal strategy.
Very useful analysis.