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How nations spend their money says a lot about the respective society. Romania vamps up arms systems, while investing less in education and public health.

But this time let‘s look at the other part of the state finances equation: revenues.

Looking at current figures, there is an unpleasant picture unfolding. Basically, according to calculations presented by several public and private experts in Banks or even state institutions, today more than 95% of all budget revenues are being spent on pensions and wages in the state sector. And this trend will most likely go on. This leaves dreadfully little for necessary investments in all things infrastructure, from schools and hospitals to roads and bridges.

That is not all. Especially in the current situation of a major health crisis and an economic downturn, Romania must allocate more funds to jump-start the economy. But there is no headroom for broader stimulus packages, because already the fiscal deficit stands at about 8%. The European Commission, no matter how inclined to turn a blind eye to overshooting deficit targets in a serious crisis, will not give the Romanian government carte blanche forever. In fact, Romania is being targeted by an excessive deficit procedure as we speak.

So everybody, left, right, and center, agrees that we need to act, and we need to act soon. Romania needs more money, but where should it come from? Some argue that aside from potential oil&gas royalties, the gigantic financial influx from the EU should be enough, but the money is earmarked for clear projects and Romania has an unconvincing record when it comes to filing applications and access the funds. And that a state‘s fiscal health should not rely exclusively on foreign aid (a questionable definition, but despite all pretentious vocabulary this is exactly what the money from Brussels boils down to) also comes to mind.

What Romania now needs is a reform toward a more functional tax system. For companies, according to what managers explain, that appears to imply not such much tax cuts, but a clearer and more predictable legal frame. If a firm can deal faster and easier with the tax authorities, instead of allocating many work hours or even outsource services to expensive tax lawyer offices, it would perhaps be even more inclined to accept higher taxes (within reasonable limits, anyway). A simpler system could in turn lead to less tax authority employees, so this is a win-win situation.

One other thing that comes to mind is the complicated mechanism by which the state pays its employees in various institutions and companies, but allows those entities to accumulate huge debt arrears to state-run pension funds and health insurance. Would it not make more sense to wire the employees the exact amount after deducting those contributions?

Still, there is also a need to reform the rest of the tax mechanism. And since the flat tax mechanism seems to be flawed, we should not hold on to a fetish just for the sake of it. But is it flawed? Let‘s look at some facts.

One goal of the flat tax approach was to obtain higher revenues due to better tax compliance, with the famous Laffer curve often cited in debates. It is seductively easy to understand. In 1974 economist Arthur Laffer argued that if the state would want to grab 100% of people‘s earnings it will end up with nothing. On the other hand, if the state would impose 0% taxes, it will also end up with nothing. So in between there lies an optimum level of taxation, where state revenues will reach their maximum potential. This theory per se is not wrong, it is just not very helpful, because it is very vague.

The degree of tax compliance is influenced by many factors other than the tax rate. It depends on how easy it is to pay taxes, on what will happens if you don‘t do it, on the perceived fairness of the respective tax system, and even on the perception of what you get from paying them, i.e. the quality of public services. There are a lot of international studies analyzing just this.

Looking at the last 15 years, the results are disappointing. After a brief period of improvement, the state revenues have decreased to all-time lows (26,4% of GDP compared to the EU-average of more than 41%), and the informal economy is estimated at more than 21% of GDP – meaning that one in every five RON is undocumented.

Second, the flat tax system started to change almost immediately after it was adopted in 2005. The initial philosophy was to have a simple, stable system and to tax all incomes with 16%, but soon it became clear that while for wage earners the new rate was an improvement, for other types of income it was far from it. This is why in the coming years, despite the fiscal code supposedly set in stone, policy rapidly morphed in often unpredictable ways. Different stakeholders – certain professional bodies, pensioners, state employees, and even business sectors – were able to convince decision-makers of their respective arguments. An increasing number of loopholes and exemptions were built into the system, while the tax burden reshifted depending on the government.

Simple and stable this was – and still is – not.

Depending on the income type, taxation changed and today greatly varies. For the same work. you can be charged 10%, but if you invoice your employer as a micro company, you will pay only 3%. One thing however never changed since 2005: no matter how high the income from any source, it is taxed evenly. This may seem fair at first glance, and despite all criticism most likely is, but is it also what Romania still needs at this point?

Fair or not fair, it is widely admitted that flat tax systems generate higher income inequality. If more equality is a desirable goal, as the constitutional reference to being a „social state“ might at least suggest, a progressive tax system could be a more sensible approach. In 2018, an EU-study found that „a significant reduction in income inequality can be achieved by moving from a flat to a progressive tax system with positive, albeit negligible, macroeconomic and employment impact.“

But despite such arguments, the progressive tax system still is demonized in liberal business circles in Romania. By contrast, the flat tax was regarded as the Holy Grail, which is not to be touched, no matter the circumstances.

Just like today, in 2010 Romania found itself in dire straits due to the financial and debt crisis. To raise more money, the government at the time refused to even consider higher income taxes, and instead resorted to a hefty increase of VAT, from 19% to 24%.

Experts have reached a consensus in this matter as well: raising indirect taxes such as VAT disproportionately affects lower-income households, which spend a bigger part of their earnings on consumption.

So increasing VAT is no real solution at this point, especially if it is done by a blanket approach over the entire spectrum of products and services, because in Romania household income is stretched thin as it is. For instance, while the statistical data indicate an average gross wage of around RON 5,500 (about EUR 1,100), in reality few people earn that much. About 5.6 million employees make less, only a little more than 800,000 have wages higher than that. No wonder that as a study by the Institute of Statistics suggests, more than 77% of households have problems in covering daily expenditures.

If the state is neither willing to increase income tax rates, nor able to charge a higher VAT, one of the few remaining options is to improve collection and/or broaden the tax base.For instance, the difference between the amount of VAT collected in Romania and the potential earnings – the so-called VAT gap – is among the highest in Europe, reaching almost 34% or EUR 6.6 billion in 2018, meaning there is much potential to increase VAT revenues. There is a lot to learn from other countries in the region, which managed to significantly reduce their VAT losses.

A larger tax base would also lead to higher revenues, but it is a trickier question. On the one hand, it makes sense for instance to repel the income tax exemptions for IT-related personnel, but on the other hand, this would likely damage the extremely competitive IT and BPO sector, because many experts and companies will be tempted to relocate to other countries.

So what other sources are there? Taxes on inheritances and property – be it cars, real estate or other type – are quasi non-existent or ridiculously low in Romania, amounting to a fast-food lunch, or, if the owner basks in luxury, a dinner in a fancy restaurant.

Populist as it may sound, taxing the rich at higher levels (even if, in contrast to countries in the West, no Romanian business mogul is asking for it) could come with a few benefits. First, it could give regular people the feeling that they are not bearing the brunt of the current crisis.

Second, because property taxes are local taxes, raising them may bolster local budgets.

At least for the time being, not much else can be done. But in the long run, a new system should be designed. Fiscal planners should maybe get their orientation from the statistics on the happiness of nations. Year after year, the World Happiness ranking is constantly dominated by Nordic countries. Lo and behold, all of them have progressive tax systems , relatively high tax levels, and (according to EU data) also a high degree of equality. By contrast, nations with flat tax systems like Romania and the Baltic states fare worse. Of course, correlation does not equal causation. But it does not automatically exclude it either, so maybe it is worth looking at how taxes, equality, and happiness interconnect.

Alex Gröblacher

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